What happened
Shares of artificial intelligence (AI) and cybersecurity enterprise software names C3.ai (AI 3.02%), Cloudflare (NET 1.44%), and Zscaler (ZS 1.28%) fell on Thursday, down as much as 9.8%, 5.3%, and 5.8%, before recovering to mere 2%, 3%, and 4.1% losses, respectively, as of 1:53 p.m. ET.
It was generally a poor day for technology stocks, and especially high-growth software names that tend to trade at higher valuations and which had already logged strong year-to-date gains.
The sell-off across AI, cybersecurity, semiconductor, and software names was likely due not to company-specific news, but rather macroeconomic data and recent public statements from Federal Reserve officials.
Ironically, a stronger-than-expected jobs estimate from a leading data provider caused today's sell-off, as investors anticipate labor market strength will spur the Federal Reserve to hike interest rates even further than it already has.
Since much of the value of growth stocks like these names lies in profits far in the future, any increase in interest rates will discount the value of those future profits by a greater degree, lowering their value in present-day terms.
So what
On Thursday, Automatic Data Processing released its June jobs growth estimate for the U.S. economy, coming in at a whopping 497,000, which was more than double the 220,000 estimated by economists. ADP's estimate isn't the official number as calculated by the Department of Labor, as those official figures will be out tomorrow. Still, this blowout number suggests upside for the soon-to-be released official figures. Of note, wage growth slowed, but still came in at a strong 6.4% annual rate.
While these weren't inflation figures, the tight labor market has been on the minds of Federal Reserve officials. Job openings have greatly outnumbered the unemployed for some time, putting upward pressure on wages and inflation. Although the Fed "paused" its aggressive interest rate hikes at the June meeting, today's figures seem to reinforce that the Federal Reserve will likely proceed with another rate hike in July.
Also of note, the 10-year Treasury bond yield rose above 4% for the first time since March, perhaps indicating bond investors see a stronger economy and higher inflation for longer than they had over the past few months.
In addition, yesterday's release of minutes from the Fed's June meeting indicated that although the Fed didn't hike rates at the last meeting, many officials thought more increases would be coming, and that many would have agreed to a June hike if that were the consensus.
In any case, a rise in long-term yields caused growth stocks like C3.ai, Cloudflare, and Zscaler to sell off. It's perhaps not unexpected to see a pullback, as each of these three stocks had a blowout first half, with C3.ai riding artificial intelligence hype to 225% gains thus far this year.
Meanwhile, both Zscaler and Cloudflare will also likely benefit from AI, as their leading cloud-based cybersecurity platforms should use huge amounts of data to improve their algorithms and products. The cybersecurity sector rebound allowed for a 45% gain for Cloudflare and 31% gain for Zscaler this year. Of note, Zscaler reported exceptionally strong results in its May earnings report, seeming to justify its high valuation.
However, the strong first-half performance also lifted these stocks' valuations to expensive-looking price-to-sales ratios in the mid to high teens. A ratio over 10 is generally considered expensive. With valuations that high, these growth stocks were thus vulnerable to a pullback.
AI Year to Date Total Returns (Monthly) data by YCharts
Now what
I wouldn't read too much into one day's or week's news regarding inflation. Inflation isn't going to cool in a straight line, and the last few months have been relatively good, with inflation declining while the economy has remained resilient. While a slight increase in rate expectations is causing a small correction, it would probably take a larger reset of rate expectations or an economic downturn to materially change the thesis on these tech stocks. Neither of those scenarios seems likely in the near term.
Still, the big gains we've seen in unprofitable tech stocks offer reasons for caution. I would be especially wary of C3.ai stock, as its massive year-to-date gain has mostly been driven by AI hype as well as new contract engagement announcements.
Yet whereas Cloudflare and Zscaler grew revenue by 37% and 46%, respectively, last quarter, C3.ai hasn't yet translated those customer engagements into revenue, with growth basically flat year over year in the recent quarter.
If rates stay higher for longer, investors may look toward stocks making profits in the here and now, making expensive growth stocks a risky bet, even if their underlying businesses show solid top-line growth. And if anticipated growth for a stock like C3.ai fails to materialize, there remains significant downside risk.
