Salesforce Inc., one of the latest big tech companies to report first-quarter results, surprised investors with a bullish forecast this week. Overall, 85% of software companies in the S&P 500 reported earnings above expectations, compared to just 79% for all technology companies, according to data compiled by Bloomberg.
Still, the group has seen some of the biggest selloffs among the sectors as investors anticipate even tighter monetary policy from the Federal Reserve. In addition to weighing on popular stocks, rising rates are driving the dollar higher while adding to concerns about a possible recession. Microsoft Corp. on Thursday lowered its forecast for this quarter due to currency strength.
“They’re more attractive than they used to be, but we won’t be chasing quality names thinking they’re still bargains,” said Stephen Hoedt, managing director of equity research at Key Private. Bank, about software stocks. “The cheap can quickly become cheaper in a rising rate environment.”
The iShares Expanded Tech-Software Sector ETF is down 24% in 2022, while a Goldman Sachs Group Inc. basket of the most expensive software names is down more than 40%. The overall S&P 500 information technology sector index fell about 18%.
The tech bear market partly reflects the yield on the 10-year Treasury, which rose to 2.9% from less than 1.35% in December. Higher rates discount the present value of expected earnings, and for highly valued software companies, most earnings are far in the future.
Microsoft is trading nearly 26 times estimated earnings, down from a recent peak above 35 but still above its 10-year average of 21. The S&P 500 Software and Services Index is at 25 times, also above its long-term average.
Even though Salesforce’s outlook spurred a rally in the stock on Wednesday, the company doubled the hit it expects to take to revenue this year due to the strong dollar. The U.S. dollar index rose more than 7% from its January low and last month hit its highest level since 2002.
According to KeyBanc Capital Markets, software stocks ended May with potential downside of up to 27% from their pre-Covid averages, when measured on an enterprise value basis. compared to free cash flow. He sees particular risk for companies with low or negative free cash flow margins.
For now, analysts are not pricing in a deteriorating environment. Brokers have raised their 2022 revenue growth estimates for software and services companies: They expect 14.1% growth, up from 13.9% at the end of January. Revenues for the overall tech sector are expected to grow 12.3% this year.
“Even though rates and the potential for recession have worsened the backdrop, we’re really excited about the multi-year software backdrop,” said Denny Fish, who manages the $4.8 billion Janus Henderson Global Technology and Innovation Fund. “You may have to wait for prices to recover, but Microsoft and Salesforce are showing the demand environment continues to be strong.”
Technical table of the day
This may be a bear market rally, but for investors in semiconductor companies, it’s a relief. Chip stocks fell the most among tech sectors during this year’s market decline, to the point that some bulls started beating the table in mid-May. The timing turned out to be fortuitous: since the bottom of the S&P 500 on May 19, semiconductors have been the best performing technology group, easily beating the benchmark. However, consumer and retail stocks are doing the best.