Software Stocks Downgraded as Analysts Focus on Valuations

Stock index futures were mostly flat before the open as investors await the Fed announcement this afternoon. The Census Bureau retail sales reports found that sales grew at a much slower pace in November despite rising prices inflating the numbers. However, stock index futures were unmoved on the report and the VIX (Cboe Volatility Index) remained slightly elevated before the open.

Apparently, all eyes are on the Fed. As investors focus on the Fed, it’s likely that volumes will be light in the morning. Light volumes carry the risk of not getting orders filled at a desirable price. Traders should consider waiting until after the meeting before placing trades or scaling into their positions to limit their risk. The reaction to the announcement will depend on how hawkish the Fed is with its need to taper faster and raise rates.

Outside of the Fed watch, everyone appears to be losing a little in the streaming wars. Netflix NFLX was downgraded Wednesday morning by Deutsche Bank. The analysts said it was hard to justify the company’s valuation because its revenue growth is slowing. However, the stock was unchanged in premarket trading. Additionally, yesterday, Morgan Stanley cut their price target on Disney DIS to $185 from $210.

Despite the popularity of electric vehicle (EV) makers, lithium producers Albemarle ALB and Livent LTHM were downgraded by Goldman Sachs on Wednesday morning from “neutral” to “sell”. EV batteries are lithium batteries, so there should be high demand for lithium so the downgrade may come as a bit of a surprise for these companies. The stocks fell 4.96% and 7.80% respectively in premarket trading.

Citi analysts see the supply chain clearing up, which prompted them to upgrade United Parcel Service UPS. UPS rallied 1.27% in premarket trading.

Stocks fell on Tuesday but trimmed some of their losses going into the close. The tech-heavy Nasdaq Composite GIDS was the biggest loser among the major indices on Tuesday. The index fell more than 2% but rallied off its lows to close 1.14% lower. The Nasdaq was drug down by the technology sector, which was the worst sector of the day. By contrast, the Dow Jones Industrial Average ($DJI) was down just 0.3% because it was buoyed by financial stocks, which rose on pop in interest rates.

The software industry group was a big drag on technology stocks which, were the worst performer on the day. The Dow Jones U.S. Software Index ($DWCSOF) fell 3.28% after JP Morgan JPM software analyst Sterling Auty issued a slew of stock downgrades and price target cuts that included companies like Adobe ADBE, Akamai AKAM, Cadence CDNS, Cloudflare NET, LegalZoom LZ, and more.

But it wasn’t all bad for software companies. Auty upgraded a few stocks like CrowdStrike CRWD and SS&C Technologies SSNC. According to Barron’s, Auty cited growth rates as the top factor to determining software valuations, which suggests that software companies could experience a slowdown in the near future.

Microsoft MSFT could be a good example of why valuations matter. It fell 3.26% on Tuesday despite not being downgraded. Analysts project that Microsoft will grow revenue by 15% over the next five years, but on Monday we learned from the Producer Price Index (PPI) that inflation for companies is growing at 9.6%. This means that inflation could eat up Microsoft’s growth, giving it an inflation-adjusted growth rate of 5.4%. Rising inflation and interest rates are forcing analysts and investors to reconsider their valuations and projections.  

Forecasting the Fed

On Tuesday, CNBC reported that analysts expect that the Fed will increase its tapering plans from $15 billion per month to $30 billion per month. Additionally, the projections include two, and possibly three, rate hikes in 2022 and three more in 2023. The target at the end of 2023 is a fed rate of 2.3%. Of course, these are only projections, and there are many factors that could influence the Fed’s decisions going forward.

Bond investors may fear that the Fed won’t raise rates fast enough. The Bank of America U.S. Corporate Index Effective Yield has an aggregate yield of 2.3%, which is about one percentage point higher than Treasuries. According to Barron’s, this is the highest spread between corporates and Treasuries since March 2021. The higher yield reflects demand from investors to get more for their money.

Of course, what the market wants and what the Fed does could be very different. But the Fed is also aware that the longer it waits to raise rates, the higher likelihood it has of feeding asset bubbles.  

CHART OF THE DAY: DEMANDING MORE. The Bank of America U.S. Corporate Index Effective Yield FRED separated from the 10-year Treasury yield (TNX—pink) when market demand differed between the assets. (An aggregate Treasury yield would be a better comparison, but there isn’t an index for it yet.) FRED® is a registered trademark of the Federal Reserve Bank of St. Louis. The Federal Reserve Bank of St. Louis does not sponsor or endorse and is not affiliated with TD Ameritrade. Data Sources: ICE, S&P Dow Jones Indices. Chart source: The thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.  

Meeting Demand: Investors commonly demand higher yields from corporate bonds than Treasury bonds because corporate bonds are considered riskier. This is because Treasuries are backed by the taxing power of the United States government, whereas corporate bonds are backed by the company and its ability to generate income.

Investment returns commonly reflect the degree of risk that investors expect. A higher rate of return usually has a higher amount of risk. However, if the rate of return is too small, it creates a different risk—that investors won’t find the investment worth their time.

Higher inflation commonly demands higher returns because inflation reduces “real returns”. With inflation rising at 6.8% according to the November Consumer Price Index, a Treasury yield of 1.48% has a real rate of return of -5.32%. In other words, low Treasury yields are a losing investment when adjusted for inflation. Of course, corporate bonds could also be a losing investment when adjusted for inflation—having a real return of -4.46% (2.34%-6.8%). But for bond investors, the one percentage point makes a difference.

If bond investors can’t get the return they want, they may choose to invest elsewhere, even if the investments are a bit riskier, such as foreign bonds, dividend-paying stocks, utilities, and real estate.

Chasing Yield: Many investors commonly move money around, looking for the highest available yields. However, there must be a certain level of risk to justify the return. Investors may be able to get a 36% current yield by investing in Venezuelan debt but also have a very high likelihood of not getting their initial investment back. Also, there is no guarantee that the investor will receive all interest payments. Currently, the United States has the highest central bank rates out of countries with high creditworthiness. New Zealand and Canada are second. Australia is third, followed by Great Britain, the European Central Bank, Japan, and Switzerland.

The higher rate in the United States is one reason the U.S. dollar has appreciated against other currencies. The U.S. Dollar Index ($DXY) has appreciated 7.41% year to date against a basket of currencies. The higher rates attract investors, including foreign governments and corporate banks from all over the world, to deposit money to the U.S. central bank.

Pairing Up: First, I need to warn you. I’m not a forex trader, so I’m going to rely on what my currency friends are telling me. Additionally, trading forex is complex, involves leverage which can result in large losses and is not suitable for everyone. Today, I’m just going to talk at a high level about forex trading and focus on how investors seek out yields and why.

One way currency traders seek higher returns is by borrowing at a low rate in one country and lending at a higher rate in another country. For example, some traders may choose to borrow Swiss francs and deposit in U.S. dollars. The interest rate in Switzerland is -0.75%. That’s right, negative interest rates, but that’s a discussion for another time. The U.S. central bank rate is 2.5%. This means forex traders are seeing a 3.25% rate of return with this pairing. On top of the interest rates, the U.S. dollar has appreciated against the Swiss franc 4.91% year to date, which may increase a forex trader’s investment, depending on how they’ve set up the trade. 

Of course, if interest rates change in either country or the U.S. dollar were to depreciate against the Swiss franc, then forex traders could lose money and even lose more than what they’re earning in interest rates. But searching for yields in different countries is a common way for some more sophisticated investors to seek a higher rate of return. 

TD Ameritrade® commentary for educational purposes only. Member SIPC.

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