Market Insights

Software stocks have been growth darlings for years, but doubts are growing on Wall Street.

Yesterday three different investment banks made bearish calls on three different companies:

• Citi downgraded Adobe Systems (ADBE) to “neutral.” The analyst thinks recurring revenue for Creative Cloud is set to decline after a year of stagnation.
• Morgan Stanley cut ServiceNow (NOW) to the equivalent of neutral, seeing risks to its growth and sky-high expectations.
• RBC Capital lowered its price target on Workday (WDAY), saying it will struggle to keep expanding at the same clip as it targets larger customers.

The actions seem unrelated, and weren’t the work of a single firm making a broad sector call. That could make the trio of negative opinions even more meaningful. When more people reach similar conclusions, they tend to have more validity.

The bearish views follow years of seemingly limitless growth for enterprise software companies. They were classic innovators, capitalizing on cloud computing to deliver an array of services over the web: design, human-resources, customer-relationship management and data-analytics.

Sky High Valuations

Investors loved how they kept expanding regardless of the economy or risks like tariffs. Their years of buying drove valuations much higher than the rest of the market.

ETFdb.com, for instance, shows that the iShares Software ETF (IGV) has price/earnings ratio of about 40. That’s more than twice the overall level for the S&P 500. It’s also quadruple the valuation for banks.

Here’s something else to think about: Investors are willing to pay a premium for growth stocks when the economy is weak and interest rates are low. But when that changes, they tend to shift toward financials and industrials.

People are still worried about the economy, especially after Wednesday’s disappointing retail-sales report. But bond yields have held their long-term lows. If we dodge a recession and they rebound, it could be a headwind for richly valued software stocks.

Relative strength may already be showing this trend. IGV has outperformed the S&P 500 on a year-to-day basis. It’s up 23 percent since January compared with the broader market’s 19 percent gain. But it’s down about 6 percent in the last three months, while the broader index is flat. That’s a potential sign of money leaving the sector.

In conclusion, software stocks had a big run since the start of 2017 but have lagged since the summer. Yesterday’s two downgrades and price-target cut seem to show that even Wall Street analysts are starting to notice.