Bets that the Federal Reserve will continue cutting interest rates have fueled a rally in one of the riskiest corners of the technology sector, raising concerns about a potential painful reversal in the stocks.
A basket of unprofitable tech companies tracked by UBS has jumped 21% since the end of July, compared with a 2.1% advance for its profitable tech counterpart and the Nasdaq 100 Index’s 5.9% advance. The run-up has sent the group, which includes lesser-known companies like SoundHound AI Inc. and Unity Software Inc., near its highest since late 2021, back when rock-bottom interest rates were fueling a bubble in speculative assets that popped the following year.
The risk of a hard landing for the stocks was highlighted on Tuesday, when the group sank 2.1%, underperforming the market after Fed Chair Jerome Powell reiterated his view that policymakers have a difficult road ahead as they weigh further rate reductions. And even if the Fed follows through with two more cuts this year, the benchmark rate will likely remain above 3%, a far cry from the zero-interest-rate policies during the pandemic.
“I think of this as a ‘crap rally,’ a phase of speculative over-exuberance because the expected rate-cut cycle is leading to animal spirits being revived,” said Ted Mortonson, a tech strategist at Robert W. Baird & Co. with more than three decades of Wall Street experience. “The rally looks extremely frothy and risky, and all the speculation from the Reddit and Robinhood crowds makes it feel like a casino, which makes me think this will end with disillusionment.”
With inflation still a problem and artificial intelligence weighing on the labor market, it’s “extremely tricky” to analyze the value of money-losing companies based on what the Fed may or may not do, Mortonson added.
Lower borrowing costs are especially crucial for money-losing tech firms that need to finance fast-growing operations and whose valuations are based on profit expectations that may not be delivered for years. Of course, there are plenty of other areas of the stock market where speculation is running rampant amid prospects for lower rates. Riskier biotech plays are surging and the Russell 2000 Index of small caps recently hit its first record since 2021. However, the move in tech has been pronounced.
A similar unprofitable basket tracked by Goldman Sachs has nearly doubled from an April low, and recently hit its highest since February 2022.
Notable winners include OpenDoor Technologies Inc., a high flying so-called meme stock championed by Canadian hedge-fund manager Eric Jackson, which has soared by more than 280% since the end of July. IonQ Inc., a quantum-computing company, is up more than 80% over the same period while SoundHound AI, Xometry Inc. and Lemonade Inc. have gained more than 50%.
Despite the rally, the moves still pale in comparison with the start of the decade. Goldman’s basket soared more than 420% from March 2020 to February 2021 before giving most of that back over the following 15 months.
Still, some investors see validity in the recent move higher, especially since the scale of the so-called dash for trash is far smaller than in the previous rate-cutting cycle. Goldman’s basket remains about 50% below its 2021 peak.
“I don’t think the exuberance is unfounded, since growth has been decent, there’s more visibility on tech earnings than other industries, AI is a unique secular tailwind, and the rate backdrop looks favorable,” said Anthony Saglimbene, chief market strategist at Ameriprise Financial Services Inc. “That’s a pretty supportive macro environment, and therefore it isn’t a stretch to see more risk taking in speculative areas, which is where you find the untapped sources for upside.”
Despite that, he stressed that the rally in unprofitable tech could easily turn, with the stocks in the group likely to face more pressure than their high-quality counterparts in the event of a broader economic downturn.
“The Fed is likely to remain guarded with its rate path, and if it starts to cut more aggressively, that’s probably because something is breaking in the economy, which won’t be positive for risky or unprofitable tech assets,” he said. “We’re in a risk-on mode right now, but if you live by the sword, you might die by it.”
Tech Chart of the Day
Alibaba Group Holding Ltd.’s shares surged to their highest in nearly four years after revealing plans to ramp up AI spending past an original $50 billion-plus target, joining tech leaders pledging ever-greater sums toward a global race for technological breakthroughs.
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