Bets on continued interest rate cuts by the Federal Reserve have driven a rally in one of the riskiest segments of the technology sector, raising concerns about a potential reversal for related stocks.
A basket of unprofitable tech stocks tracked by UBS Group has surged 22% since the end of July, compared to a mere 2.5% rise for profitable tech stocks and a 5.9% gain for the Nasdaq 100 Index over the same period. This rally has pushed the index – which includes lesser-known companies such as SoundHound AI Inc. and Unity Software Inc. – close to its highest point since late 2021, when ultra-low interest rates fueled a speculative asset bubble that burst the following year.
On Wednesday, the index of loss-making tech stocks rose by 0.7%, while the index of profitable tech stocks increased by 0.4%.
The risk of a hard landing for the stock market was highlighted on Tuesday, as unprofitable tech stocks fell 2.1%, underperforming the broader market. Federal Reserve Chair Jerome Powell reiterated that policymakers face tough choices as they weigh further adjustments to interest rates. Even if the central bank cuts rates twice more this year, the benchmark rate is still likely to remain above 3%, far from the zero-rate policies that fueled stock market gains during the pandemic.
The movement in loss-making tech stocks marks the arrival of 'a phase of speculative excess and euphoria, as the anticipated rate-cutting cycle reignites the market’s animal spirits,' noted Ted Mortonson, a tech strategist at Robert W. Baird & Co. 'This rally appears highly frothy and extremely risky, with various speculative activities by Reddit and Robinhood retail investors making the market resemble a casino. I believe it will ultimately end in disillusionment.'
Mortonson added that assessing the value of loss-making companies based on what the Fed may or may not do is 'extremely tricky' amid persistent inflation and the impact of artificial intelligence on the labor market. Lower borrowing costs are crucial for these companies, which rely on financing to sustain high growth and whose valuations are based on profit expectations that may take years to materialize.
Nevertheless, some investors view the recent rally as justified, especially considering that the scale of this so-called 'junk buying spree' is smaller than in previous rate-cutting cycles.
Anthony Saglimbene, Chief Market Strategist at Ameriprise Financial Services Inc., stated, 'I don’t think this enthusiasm is entirely unfounded, as economic growth remains robust, the earnings outlook for the tech sector is clearer than for other industries, artificial intelligence represents a unique long-term tailwind, and the interest rate environment is relatively favorable.' He noted, 'It’s not surprising to see more risk-taking behavior in speculative areas, where untapped upside potential exists.'
Nonetheless, Saglimbene emphasized that the rally in loss-making tech stocks could easily reverse, and these stocks would face greater pressure than high-quality tech stocks in the event of a full economic downturn.
"The Federal Reserve may continue to cautiously adjust the interest rate path. If it begins to cut rates more aggressively, it could be due to signs of economic distress, which would not be a positive development for high-risk or loss-making tech assets," he cautioned. "While the current market is in risk-on mode, what brought success could also lead to failure."