What's Going On with Tech Stocks?

By Bobby Chen
Analyst, mPower

In This Story Overall Market Conditions Tech in the Driver's Seat Shifts in Investor Sentiment Changes in Fundamentals The Telecom Outlook Diversify, Diversify, Diversify

Investing in technology stocks became a whole new ball game this year. Financial headlines regularly use the words "tumble" and "free fall" to describe technology stock moves, in stark contrast to the record-setting advances of 1999.

Many names in the sector have accumulated enough red ink to last them a long while. And, by the end of November, the tech-laden NASDAQ sank to its lowest level in more than a year.

minute: read this article at a glance.

Technical Terms Float Lockup period Tax-loss selling

Overall Market Conditions

Not every area of the market is weak. Some long-neglected companies in traditional "value" sectors — whose shares tend to trade at a discount to their underlying worth based on assets and earnings — have performed extremely well amidst the technology turmoil.

In general, financial stocks have done well, primarily on the strengths of increased industry consolidation and record profits from America's newfound hobby: investing. High energy prices coupled with record demand have piqued investor interest in energy and utility stocks. The health care sector, led by pharmaceuticals and the surging biotech group, is up strong on positive drug pipelines and optimistic demographic trends. Even some names in the long-beleaguered consumer staples and cyclical sectors — including Safeway, Philip Morris, and Nabisco — have rallied in 2000.

All in all, it's been a pretty solid year for almost every sector outside of technology and telecom. But, where do most investors have their largest exposure? In those two sectors.

Tech in the Driver's Seat

At the end of November, technology and telecom stocks made up close to 29.6 percent of the S&P 1500. Technology companies represent the largest investment universe for growth and blend mutual funds. Over the last several years, most of the eye-popping gains in the market and in mutual funds came from technology stocks.

So, movements within the tech sector tend to drive market indexes more than any other sector. After a record-setting year in 1999, during which the NASDAQ appreciated by almost 86 percent, tech stocks are taking it on the chin in 2000. Through Nov. 30, 2000, the NASDAQ is down 37 percent year-to-date.

The critical question now is: Have the fundamentals of the downtrodden technology firms changed much since their heyday before the March correction? After all, stocks of many tech firms are trading at 50 percent to 90 percent below their all-time highs achieved just months earlier. The answer is that those fundamentals probably have not changed much, but to argue that the selling has been overdone is to assume that many of the profitless start-ups with minimal sales were worth the billions they were valued at before.

Shifts in Investor Sentiment

What has changed dramatically since early 2000 is investor sentiment, particularly with respect to "concept" companies. Companies that sounded good on paper but went public before developing steady revenue streams — such as Webvan, priceline.com and WebMD — are now finding no safe haven and their stock prices have been severely punished.

Boring fundamental metrics such as price-to-earnings, price-to-sales, and price-to-book ratios, which were considered inconsequential by market bulls last year, are points of debate once again. Just as the market didn't need a reason to go up during its record rally, it doesn't need a reason to go down now.

Just as the market didn't need a reason to go up during its record rally, it doesn't need a reason to go down now.

This change in sentiment has altered the way investors allocate their assets. Those who can't stomach tech stock volatility have rotated some money out of technology and into less glamorous sectors, which has contributed to some of the gains in the other sectors. According to AMG Data Services, roughly $62 billion went into technology-focused mutual funds during the fourth quarter of 1999 and first quarter of 2000, representing about one in every four dollars that went into equity products. That number down was down to about $3 billion during 2000's third quarter and has since dwindled substantially.

When money was pouring into the tech sector, it was easy to float all boats. Now that the money is drying up, the momentum train has stopped dead in its tracks. To a large degree, last year's investor enthusiasm (commonly known as greed) contributed to the current downturn of technology stocks.

Many companies that went public in 1999 had incredibly small float, or shares, available to the public market. With so much money chasing such thin floats, stock prices rocketed. As tech stocks declined this year, demand fell as investors pulled their money out. That, coupled with expiration of lockup periods, which increased the float, has put great downward pressure on tech share prices.

Changes in Fundamentals

Aside from hard-to-quantify influences like sentiment and momentum, some measurable economic factors are contributing to the market's woes.

• Slower economic growth. The latest figures released by the Bureau of Economic Analysis indicate the economy only grew 2.4 percent in the third quarter, the weakest quarter since 1996. Economic growth has indeed slowed and, according to most observers, is projected to be a more modest 3 percent to 4 percent on an annualized basis for 2000, compared with growth in excess of 5 percent in the previous few years. The slowdown is largely due to the Federal Reserve Board's efforts to curb inflation by raising interest rates six times in the past 18 months. The subsequent slowdown in consumer spending is good for the economy because it relieves inflationary pressure but it has left some companies a bit short of their profit expectations in the near term.
• Higher energy prices. Inflation has not become a huge concern based on various leading economic indicators, but if high energy prices persist, that may change. High energy prices are seen as a potential inflationary threat to our economy.
• Lower corporate profits. Based on figures from the Bureau of Economic Analysis, corporate profits growth slowed significantly to 3.2 percent on an annualized basis. Companies that have consistently exceeded market expectations in the past are finding future growth targets a bit lofty. A weak euro has wreaked havoc on companies that do a lot of business in Europe by reducing their earnings when converted back into U.S. dollars. Consequently, we have seen downward earnings revisions by both Wall Street and the companies themselves.
• A cyclical downturn in the semiconductor industry. The semiconductor industry is notorious for its boom-and-bust cycles. The health of this industry is heavily dependent on the balance between supply and demand. If demand greatly exceeds supply, there will be chip shortages like we saw last year, which drives up margins and lifts semiconductor stock prices. Conversely, if supply outstrips demand, then inventory gluts will reduce prices, which in turn reduces earnings. Within certain segments of the chip markets — most notably the PC and wireless segments — demand is softening because companies are already carrying a lot of inventory. The semiconductor group was among the strongest and best-performing in 1999, advancing 101 percent based on the Philadelphia Semiconductor Index, but now its cyclical nature has cast a dark cloud over the whole sector.

The Telecom Outlook

Telecom Prospects Vary It is inappropriate to paint all telecom stocks, or tech stocks for that matter, with the same brush, as business varies greatly from company to company. Demand for gear that goes into traditional voice-based networks is not expected to grow. This is partially responsible for the downfall of Lucent, which has substantial exposure to that segment. Judging from conversations with portfolio managers and analysts, demand for next-generation equipment for data networks remains robust and sales will continue to grow rapidly. The debate surrounding reduced capital expenditures is ongoing. Sanford Bernstein, the venerable research house, raised the issue late last year. It wasn't until recent months that other major Wall Street brokerage houses joined the bashing, with Morgan Stanley being the latest to downgrade its guidance for upstarts such as Juniper Networks and Redback Networks. The bull argument is that while overall capital expenditure for 2001 is expected to slow, demand for next-generation equipment, particularly optical networking gear, is expected to accelerate. What this means is that even if the overall sector swoons, selected data equipment companies may still do very well.

What about the high-and-mighty optical stocks that we covered in an earlier article (Moving at the Speed of Light — Optical Technologies)? Well, those are also down considerably from their highs. Top-tier system suppliers such as Nortel and Lucent have both run into problems; and, within the last three months, both companies lowered their revenue targets for the coming year.

Much of the decline in optical stocks can be linked to the reduction in capital spending by big telecom carriers, such as AT&T and WorldCom. Telecom stocks are down by more than 34 percent through Nov. 30, 2000 based on returns of the S&P 1500. Companies like AT&T and WorldCom that have large exposure to long-distance services were particularly hurt due to deteriorating margins on their services.

In an effort to boost their sagging stock prices, both AT&T and WorldCom recently announced initiatives to separate their higher-margin data services units from the rapidly declining long-distance services. (For more on the AT&T breakup, read The Morphing of AT&T.) The uncertainty surrounding these events does not bode well for equipment providers who get the bulk of their business from the big telecom carriers.

Additional downside pressure on telecom stocks comes from the extraordinarily high debt within the sector. The rush to build new data networks encouraged many companies to enter the market over the last couple of years. Because the initial capital outlay is so high, many of these upstart telecom companies turned to debt financing to expand their operations. According to Lehman Brothers, high-yield bonds (also known as "junk bonds") issued by telecommunications companies comprise almost 23 percent of the U.S. Corporate High Yield Index as of October, by far the largest exposure of any sector. Over the last 18 months or so, more than half of new junk bond issues have come from the telecom sector.

Now that market conditions have changed, access to capital has tightened and a few upstart telecom carriers have gone belly up. This is a double whammy for equipment suppliers because many of them routinely offer financing for customers to buy their products. Now, not only are they having trouble collecting some of that revenue, there are also fewer customers to buy their products.

Diversify, Diversify, Diversify

Now that we've identified the problems, what about the fourth-quarter rally? With NASDAQ headed for its worst year in well over a decade, it's unlikely we'll have the same kind of rally as last year. Year-end tax-loss selling may put additional selling pressure on an already jittery market. Granted, some fundamental concerns are still hanging over the market; but, without getting overly simplistic, stock prices and investor expectations may have become too high after last year's record rally. The presidential recount controversy only adds fuel to the fire.

Related Reading The Morphing of AT&T Moving at the Speed of Light — Optical Technologies What Every Investor Should Know about High-tech

But all in all, no big catastrophe has occurred since March, despite what your monthly account statements say. The economy is still trotting along nicely. Corporate profits are still relatively healthy. Record growth is still expected in many industries. Inflation is contained and unemployment is still at a record low.

Investors should maintain a long-term perspective and not overreact to short-term market conditions. Just as real estate is all about location, location, location; strategic asset allocation is all about diversification, diversification, diversification. Maintaining a broadly diversified portfolio is key to smoothing out the market's ups and downs over the long haul, thus maximizing the probability of reaching your retirement goals. 

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

What's Going On with Tech Stocks?

By Bobby Chen
Analyst, mPower

In This Story Overall Market Conditions Tech in the Driver's Seat Shifts in Investor Sentiment Changes in Fundamentals The Telecom Outlook Diversify, Diversify, Diversify

Investing in technology stocks became a whole new ball game this year. Financial headlines regularly use the words "tumble" and "free fall" to describe technology stock moves, in stark contrast to the record-setting advances of 1999.

Many names in the sector have accumulated enough red ink to last them a long while. And, by the end of November, the tech-laden NASDAQ sank to its lowest level in more than a year.

minute: read this article at a glance.

Technical Terms Float Lockup period Tax-loss selling

Overall Market Conditions

Not every area of the market is weak. Some long-neglected companies in traditional "value" sectors — whose shares tend to trade at a discount to their underlying worth based on assets and earnings — have performed extremely well amidst the technology turmoil.

In general, financial stocks have done well, primarily on the strengths of increased industry consolidation and record profits from America's newfound hobby: investing. High energy prices coupled with record demand have piqued investor interest in energy and utility stocks. The health care sector, led by pharmaceuticals and the surging biotech group, is up strong on positive drug pipelines and optimistic demographic trends. Even some names in the long-beleaguered consumer staples and cyclical sectors — including Safeway, Philip Morris, and Nabisco — have rallied in 2000.

All in all, it's been a pretty solid year for almost every sector outside of technology and telecom. But, where do most investors have their largest exposure? In those two sectors.

Tech in the Driver's Seat

At the end of November, technology and telecom stocks made up close to 29.6 percent of the S&P 1500. Technology companies represent the largest investment universe for growth and blend mutual funds. Over the last several years, most of the eye-popping gains in the market and in mutual funds came from technology stocks.

So, movements within the tech sector tend to drive market indexes more than any other sector. After a record-setting year in 1999, during which the NASDAQ appreciated by almost 86 percent, tech stocks are taking it on the chin in 2000. Through Nov. 30, 2000, the NASDAQ is down 37 percent year-to-date.

The critical question now is: Have the fundamentals of the downtrodden technology firms changed much since their heyday before the March correction? After all, stocks of many tech firms are trading at 50 percent to 90 percent below their all-time highs achieved just months earlier. The answer is that those fundamentals probably have not changed much, but to argue that the selling has been overdone is to assume that many of the profitless start-ups with minimal sales were worth the billions they were valued at before.

Shifts in Investor Sentiment

What has changed dramatically since early 2000 is investor sentiment, particularly with respect to "concept" companies. Companies that sounded good on paper but went public before developing steady revenue streams — such as Webvan, priceline.com and WebMD — are now finding no safe haven and their stock prices have been severely punished.

Boring fundamental metrics such as price-to-earnings, price-to-sales, and price-to-book ratios, which were considered inconsequential by market bulls last year, are points of debate once again. Just as the market didn't need a reason to go up during its record rally, it doesn't need a reason to go down now.

Just as the market didn't need a reason to go up during its record rally, it doesn't need a reason to go down now.

This change in sentiment has altered the way investors allocate their assets. Those who can't stomach tech stock volatility have rotated some money out of technology and into less glamorous sectors, which has contributed to some of the gains in the other sectors. According to AMG Data Services, roughly $62 billion went into technology-focused mutual funds during the fourth quarter of 1999 and first quarter of 2000, representing about one in every four dollars that went into equity products. That number down was down to about $3 billion during 2000's third quarter and has since dwindled substantially.

When money was pouring into the tech sector, it was easy to float all boats. Now that the money is drying up, the momentum train has stopped dead in its tracks. To a large degree, last year's investor enthusiasm (commonly known as greed) contributed to the current downturn of technology stocks.

Many companies that went public in 1999 had incredibly small float, or shares, available to the public market. With so much money chasing such thin floats, stock prices rocketed. As tech stocks declined this year, demand fell as investors pulled their money out. That, coupled with expiration of lockup periods, which increased the float, has put great downward pressure on tech share prices.

Changes in Fundamentals

Aside from hard-to-quantify influences like sentiment and momentum, some measurable economic factors are contributing to the market's woes.

• Slower economic growth. The latest figures released by the Bureau of Economic Analysis indicate the economy only grew 2.4 percent in the third quarter, the weakest quarter since 1996. Economic growth has indeed slowed and, according to most observers, is projected to be a more modest 3 percent to 4 percent on an annualized basis for 2000, compared with growth in excess of 5 percent in the previous few years. The slowdown is largely due to the Federal Reserve Board's efforts to curb inflation by raising interest rates six times in the past 18 months. The subsequent slowdown in consumer spending is good for the economy because it relieves inflationary pressure but it has left some companies a bit short of their profit expectations in the near term.
• Higher energy prices. Inflation has not become a huge concern based on various leading economic indicators, but if high energy prices persist, that may change. High energy prices are seen as a potential inflationary threat to our economy.
• Lower corporate profits. Based on figures from the Bureau of Economic Analysis, corporate profits growth slowed significantly to 3.2 percent on an annualized basis. Companies that have consistently exceeded market expectations in the past are finding future growth targets a bit lofty. A weak euro has wreaked havoc on companies that do a lot of business in Europe by reducing their earnings when converted back into U.S. dollars. Consequently, we have seen downward earnings revisions by both Wall Street and the companies themselves.
• A cyclical downturn in the semiconductor industry. The semiconductor industry is notorious for its boom-and-bust cycles. The health of this industry is heavily dependent on the balance between supply and demand. If demand greatly exceeds supply, there will be chip shortages like we saw last year, which drives up margins and lifts semiconductor stock prices. Conversely, if supply outstrips demand, then inventory gluts will reduce prices, which in turn reduces earnings. Within certain segments of the chip markets — most notably the PC and wireless segments — demand is softening because companies are already carrying a lot of inventory. The semiconductor group was among the strongest and best-performing in 1999, advancing 101 percent based on the Philadelphia Semiconductor Index, but now its cyclical nature has cast a dark cloud over the whole sector.

The Telecom Outlook

Telecom Prospects Vary It is inappropriate to paint all telecom stocks, or tech stocks for that matter, with the same brush, as business varies greatly from company to company. Demand for gear that goes into traditional voice-based networks is not expected to grow. This is partially responsible for the downfall of Lucent, which has substantial exposure to that segment. Judging from conversations with portfolio managers and analysts, demand for next-generation equipment for data networks remains robust and sales will continue to grow rapidly. The debate surrounding reduced capital expenditures is ongoing. Sanford Bernstein, the venerable research house, raised the issue late last year. It wasn't until recent months that other major Wall Street brokerage houses joined the bashing, with Morgan Stanley being the latest to downgrade its guidance for upstarts such as Juniper Networks and Redback Networks. The bull argument is that while overall capital expenditure for 2001 is expected to slow, demand for next-generation equipment, particularly optical networking gear, is expected to accelerate. What this means is that even if the overall sector swoons, selected data equipment companies may still do very well.

What about the high-and-mighty optical stocks that we covered in an earlier article (Moving at the Speed of Light — Optical Technologies)? Well, those are also down considerably from their highs. Top-tier system suppliers such as Nortel and Lucent have both run into problems; and, within the last three months, both companies lowered their revenue targets for the coming year.

Much of the decline in optical stocks can be linked to the reduction in capital spending by big telecom carriers, such as AT&T and WorldCom. Telecom stocks are down by more than 34 percent through Nov. 30, 2000 based on returns of the S&P 1500. Companies like AT&T and WorldCom that have large exposure to long-distance services were particularly hurt due to deteriorating margins on their services.

In an effort to boost their sagging stock prices, both AT&T and WorldCom recently announced initiatives to separate their higher-margin data services units from the rapidly declining long-distance services. (For more on the AT&T breakup, read The Morphing of AT&T.) The uncertainty surrounding these events does not bode well for equipment providers who get the bulk of their business from the big telecom carriers.

Additional downside pressure on telecom stocks comes from the extraordinarily high debt within the sector. The rush to build new data networks encouraged many companies to enter the market over the last couple of years. Because the initial capital outlay is so high, many of these upstart telecom companies turned to debt financing to expand their operations. According to Lehman Brothers, high-yield bonds (also known as "junk bonds") issued by telecommunications companies comprise almost 23 percent of the U.S. Corporate High Yield Index as of October, by far the largest exposure of any sector. Over the last 18 months or so, more than half of new junk bond issues have come from the telecom sector.

Now that market conditions have changed, access to capital has tightened and a few upstart telecom carriers have gone belly up. This is a double whammy for equipment suppliers because many of them routinely offer financing for customers to buy their products. Now, not only are they having trouble collecting some of that revenue, there are also fewer customers to buy their products.

Diversify, Diversify, Diversify

Now that we've identified the problems, what about the fourth-quarter rally? With NASDAQ headed for its worst year in well over a decade, it's unlikely we'll have the same kind of rally as last year. Year-end tax-loss selling may put additional selling pressure on an already jittery market. Granted, some fundamental concerns are still hanging over the market; but, without getting overly simplistic, stock prices and investor expectations may have become too high after last year's record rally. The presidential recount controversy only adds fuel to the fire.

Related Reading The Morphing of AT&T Moving at the Speed of Light — Optical Technologies What Every Investor Should Know about High-tech

But all in all, no big catastrophe has occurred since March, despite what your monthly account statements say. The economy is still trotting along nicely. Corporate profits are still relatively healthy. Record growth is still expected in many industries. Inflation is contained and unemployment is still at a record low.

Investors should maintain a long-term perspective and not overreact to short-term market conditions. Just as real estate is all about location, location, location; strategic asset allocation is all about diversification, diversification, diversification. Maintaining a broadly diversified portfolio is key to smoothing out the market's ups and downs over the long haul, thus maximizing the probability of reaching your retirement goals. 

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.