Gearstd
Year to date, iShares Expanded Tech-Software Sector ETF (BATS: IGV) suffered more losses than the S&P 500 and NASDAQ index as software stocks were hit harder by rising rates, slowing economic growth, and high valuations. IGV lost about 32% of its value away from 2022 and currently trading slightly above mid-June levels. Despite the recent price drop, now is not the right time to buy IGV due to dismal fundamentals. The market has begun to feel the real impact of the economic slowdown and high rates, with expectations that these headwinds will intensify over the next 3 to 9 months.
Interest Rates and the Recession
The NASDAQ is already in a bear market and is currently trading slightly above its mid-June lows. In the first half of the year, the index fell into a bear market due to concerns over rising inflation, steady interest rate growth, and economic instability. However, those concerns became a reality in the second half as inflation and interest rates began to negatively impact corporate earnings and GDP growth quarter on quarter.
Bridgewater Associates founder Ray Dalio predicts that the Federal Reserve could nearly double rates from current levels to around 4.5%, and the stock market would drop another 20% if that happens. . He added that it is highly likely that the Fed will tighten monetary policy for the foreseeable future and that it will take time for the authorities to make a significant economic contraction to tame inflation. Next year, he predicts a high chance of a recession in the US economy.
Dalio’s prediction seems worth considering given the dark outlook and historical trends. The Federal Reserve Bank of Philadelphia expects annual GDP growth to be around 1.6% for 2022, which means the economy will continue to shrink into the second half of the year. It also represents a significant contraction from GDP growth of 6% in 2021. The most worrying aspect is that some forecasts predict GDP growth for 2023 to be in the range of 0.3% to 1%. Moreover, Fitch expects the US to enter recession by mid-2023 while the prospects for a global recession are also growing due to the slowdown in the US, Chinese and European economies.
Bloomberg (Stock Performance in Recession))
Historical data also suggests that Dalio may be right about stock price movements. In each of the last 10 recessions, US stocks fell an average of 29%. So far in 2022, the S&P 500 is down about 19%, and it needs to drop another 10% to reach the average level. On the other hand, high beta software-focused ETFs may experience higher volatility than the rest of the market if interest rates rise and the economy falls into recession. As a result, software stocks may struggle to ride out economic uncertainty and higher rates in the near future.
Another Risk is Loss of Income
Yardeni.com (Revenue Forecast)
Economic uncertainty and high rates directly affect the growth trends of the software industry. Clearly, enterprise demand is weakening, and estimates are falling rapidly. It is expected that software revenues could grow by 13.7% in 2022, a significant decrease from around 34% growth last year and 20% during the pandemic. In addition, the forecast shows that revenues are likely to weaken in the next year from 2022. The future seems even darker if we look at the general trend of the information technology sector. According to FactSet data, information technology sector revenues are expected to decline by a negative 4.1% over previous expectations for growth of more than 5%. Additionally, Seeking Alpha quant data shows that 6 of IGV’s top 10 stock holdings received poor scores on earnings changes. Oracle Corporation (ORCL) annual earnings estimates have been downgraded by 23 analysts over the past 90 days, while only one analyst looks bullish. Additionally, 21 analysts lowered ServiceNow (NOW)’s earnings estimate and 32 analysts revised Microsoft’s (MSFT) outlook.
Values
Yardeni.com (Forward PE Ratio)
The forward price-to-earnings ratio of software stocks has declined in the last two quarters and is now hovering near its five- and ten-year averages. Despite this, valuations limit the stock’s upside amid declining earnings expectations. Any rally in stocks without earnings growth seems unsustainable because it could make stocks expensive based on the price-to-earnings ratio. The trend was also observed during the last bear market in mid-June to mid-August. After a mid-June price rally, the tech-heavy NASDAQ’s price-to-earnings ratio jumped back to a late-2021 level of 28.6 from mid-June lows of 20x. As a result of lower earnings, economic problems, and increased volatility, I don’t think investors will pay a premium in tech and software stocks.
Quant Rating
Looking for Alpha (Quant Rating)
IGV earned a sell rating from Seeking Alpha with a quant score of 1.53 out of 5. The ETF received a negative D momentum grade, suggesting technical factors are supporting a downward move. A D grade on the risk factor also indicates challenging times ahead. The ETF is vulnerable to various types of risks including economic uncertainty and high rates. The low asset flow score also reflects investors’ lack of confidence in the ETF.
In Conclusion
The basic principle of investing is to buy low and sell high. However, to avoid losses and maximize gains, it is important to choose the right entry point. With a sharp decline in valuations for software stocks, IGV looks attractive, but there is also the possibility of more volatility ahead due to the looming recession and high interest rates. Therefore, the idea of buying the IGV ETF ahead of potentially broader market volatility does not seem prudent.