What happened
Shares of high-growth software stocks Datadog (DDOG -3.94%), CrowdStrike (CRWD -3.90%), and Atlassian (TEAM -1.06%) were rallying on Friday, rising 6.7%, 4%, and 5.3%, respectively, as of 2 p.m. ET.
The synchronous moves across these three software plays suggest a broader theme, which likely came from today's personal consumption expenditures price index, or PCE -- a measure of inflation closely watched by the Federal Reserve. The Fed tends to prefer the PCE because the PCE changes its weightings more frequently than the CPI, and tends to reflect customer buying behavior, such as "trading down" in times of inflation to understand what consumers are actually paying for goods and services.
Fortunately, that figure for February came in cooler than expected, and lower inflation measures tend to be great news for growth tech stocks.
So what
Today, the Bureau of Economic Analysis released the February PCE. February's reading showed 0.3% month-over-month growth, or 5% year over year, compared with 0.6% and 5.3%, respectively, in January. Stripping out the more volatile food and energy categories, "core" PCE rose 0.3% and 4.6%. That monthly inflation gauge was below expectations for 0.4%.
Needless to say, this was a very welcome report, especially as personal income also rose 0.3%, in line with core inflation. That means the American consumer isn't losing purchasing power even as inflation is declining. The report also dovetails somewhat with yesterday's unemployment claims of 198,000 for the week ended March 25, which was a bit higher than expected.
While no one likes to see people out of work, that is still a very low number by historical standards, and suggests that there may be more slack forming in the labor market. The U.S. has had a "too-hot" jobs market for about 18 months, which has been a driver of services inflation. So, to see claims ticking up but still remaining low suggests inflation may decline, hopefully without a meaningful surge in unemployment.
In any case, the news is very encouraging for growth stocks, especially beaten-down SaaS stocks like Datadog, CrowdStrike, and Atlassian. While each of these companies is posting impressive top-line growth, especially in this environment, and generally beat analyst expectations for both revenue and adjusted profits in their recently reported quarters, none of these three companies is making positive profits today. Each of them probably could, but are investing in what they see as a long-term growth opportunity.
That's probably the correct move for each. But even if these companies achieve their goals, economywide inflation would hurt the value of their respective stock prices. This is because the higher inflation is, the higher long-term interest rates tend to be. The higher long-term interest rates are, the more future earnings are discounted in present-day terms.
For instance, if you expect a company to earn $10 in profits 10 years from now and discount those profits at a 10% rate, those profits are worth $3.86 in present-day terms. However, if you only discount that future $10 by an 8% discount rate, the value of those earnings today would be $4.63. That's a 20% difference.
Since Datadog, CrowdStrike, and Atlassian are all leaders in cloud software, and appear to have products and models resonating with customers -- Datadog in software observability and tech infrastructure health, CrowdStrike in cybersecurity, and Atlassian in project management and customer service software -- each company is likely to grow through a potential near-term economic downturn. Therefore, the next year or so of revenue and earnings might not be nearly as important to these stocks as the level of long-term interest rates. That's why when inflation shows signs of declining, these types of stocks benefit – even if it raises questions about near-term economic growth and the potential for a recession.
DDOG PS Ratio data by YCharts
Now what
These three companies each appear to have winning business models, strong leadership, and excellent growth prospects, making them targets for younger investors with a long time horizon. Still, with each stock still trading at frothy multiples between 13.6 and 14.2 times their sales, each will have to keep up strong operational performance to justify their valuations. And that has to happen in conjunction with continued moderation in inflation.
Remember, the Federal Reserve hasn't quite quashed inflation back to its 2% just yet, even though February's numbers offered some optimism after the hot reading in January. So, there still isn't much margin of safety in these stocks, making them appropriate only for those with a long time horizon, and who can handle near-term volatility.
