(Bloomberg) — Even better-than-expected earnings haven’t been enough to stem this year’s rout in software stocks, and now the sector is getting hit with another headwind: the stronger dollar.
Salesforce Inc., one of the last big tech companies to report first-quarter earnings, surprised investors with a bullish forecast this week. Overall, 85% of software companies in the S&P 500 reported profits that beat expectations, versus just 79% for all tech companies, according to data compiled by Bloomberg.
Yet the group has experienced some of the sharpest selling among sectors because investors are looking ahead to even tighter monetary policy from the Federal Reserve. Besides weighing on highly valued stocks, rising rates are driving the dollar up while also adding to concern about a possible recession. Microsoft Corp. on Thursday lowered its forecast for this quarter because of the currency’s strength.
“They’re more attractive than they were, but we won’t chase the quality names lower thinking they’re bargains yet,” Stephen Hoedt, managing director of equity research at Key Private Bank, said of software stocks. “Cheap can quickly become cheaper in a rising-rate environment.”
The iShares Expanded Tech-Software Sector ETF is down 26% in 2022, including a drop of 1.6% in Friday’s session. A Goldman Sachs Group Inc. basket of the priciest software names is down more than 45%. The overall S&P 500 information technology sector index has fallen about 20%.
The tech bear market in part reflects the yield on the 10-year Treasury note, which has risen to 2.9% from below 1.35% in December. Higher rates discount the present value of expected profits, and for highly valued software companies most of the earnings are far off in the future.
Microsoft trades near 26 times estimated earnings, down from a recent peak above 35 but still over 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 Wednesday, the company doubled the hit it expects to take to its revenue this year because of the dollar’s strength. The US Dollar Index has risen more than 7% off a January low, and last month hit its highest since 2002.
According to KeyBanc Capital Markets, software stocks ended May with downside potential of as much as 27% to their pre-Covid averages, when measured on the basis of enterprise value to free cash flow. It sees particular risk for companies with low or negative free-cash-flow margins.
For now, analysts aren’t pricing in a deteriorating environment. Brokerages have raised their estimates for 2022 revenue growth for software and services companies: They expect growth of 14.1%, up from 13.9% in late January. Revenue for the overall tech sector is predicted to rise 12.3% this year.
“Even though rates and the potential for a recession have soured the backdrop, we are really enthusiastic about the multiyear backdrop for software,” said Denny Fish, who manages the $4.8 billion Janus Henderson Global Technology and Innovation Fund. “You might need to bide your time for prices to recover, but Microsoft and Salesforce show the demand environment continues to be strong.”
Tech Chart of the Day
This may be a bear market rally, but for investors in semiconductor companies it’s coming as quite a relief. Chip stocks fell the most among technology sectors in this year’s market plunge, to the point that some bulls started to pound the table in the middle of May. The timing proved fortuitous: Since the S&P 500 bottomed on May 19, semiconductors have been the best-performing tech group, easily beating the benchmark. Consumer and retail stocks are faring the best though.
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(Updates to market open.)
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