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Outlook For Tech Stocks
What lies ahead for this battered group?

I'm not one for bold predictions but over the past year, it was tough to ignore the urge to call for the "tech bubble's" inevitable burst. I made my first formal recommendation to lighten up on tech stocks back in mid-September and reiterated that same sentiment in mid-October. Now, we're near year's end and the Nasdaq 100 index is down about 34 per cent since mid-September and more than 54 per cent from its spring peak. Those types of declines usually signal a buy but have tech stocks finally bottomed or is there more risk ahead for this volatile sector?

Potential opportunities

There are a couple of factors that point to some upside potential for technology stocks. First, the mere occurrence of the strong declines we've seen so far, by definition, have taken out some of the downside risk. A decline of 54 per cent would appear, on the surface, to be sufficient to eliminate most of the potential downside risk - especially when you consider that analysts' consensus expectations for future revenue and profit growth remains relatively strong. With the US economy (and many other developed nations) showing clear signs of slowing, it is likely that interest rates will begin declining early next year. Generally speaking, falling interest rates increases the value of stocks because it makes future earnings worth more today. Finally, there is the seasonal effect of stock prices. Historically, the period of November to April has been strong for stock prices.

Reality check

On the flip side of the above positive factors are offsetting potential downsides. Though big declines often precede strong gains, that relationship isn't carved in stone by any measure. Is this year's decline in the Nasdaq - and tech stocks - enough to make this a buying opportunity? It depends on time horizon, current stock valuations, and future profit growth. In previous articles, I looked at valuation of tech stocks by examining the biggest stocks on the Nasdaq exchange. The top seven stocks on the Nasdaq 100 index make up about one-third of this index. In order of their weightings, they are: Cisco, Microsoft, Intel, Oracle, Qualcomm, JDS Uniphase, and Veritas Software. Recall that stocks are often expressed in relation to their per share revenues, earnings, and/or cash flows for comparison purposes. Nasdaq's group of seven trade at the following valuations:

  • price-to-earnings: 50.8 times;
  • price-to-cash-flow: 247.8 times (or 94.6 times if you exclude JDS' ratio of 861 times); and
  • price-to-revenue: 16.7 times.

    Due to a lack of sufficient data, the above ratios are simple averages (with negatives excluded), not weighted averages. If weighted average figures were calculated, the numbers would be somewhat different. I estimate that a weighted average calculation for the price-to-cash flow ratio would likely still exceed 50 times. However, my sense is that the overall conclusion wouldn't change all that much. The numbers listed above indicate that stock valuations for this group remain on the high side. Two factors need to be considered in conjunction with current valuations - time horizon and future growth. The longer the time horizon, the better chance investors have of realizing an acceptable level of return. As for future growth, it would still take some fairly optimistic growth rates over the next five years to deliver on the expectations that are built into current prices. Based on the current state of the economy and apparent trends, investors may be wise to temper their expectations for the future growth of tech businesses.

    While falling interest rates is a positive by-product of a slowing economy, decreased capital expenditures have the opposite effect. Many investors don't think of technology companies as cyclical businesses, but the fact is that many are sensitive to the business cycle. The strength of the economy directly impacts the big money that companies plough into capital spending. In the US, approximately 60 per cent of all capital spending is on technology equipment. Assuming the current trend in economic growth will be sustained, it is reasonable to expect capital spending, and hence demand for technology equipment, to be directly affected. In fact, we've already seen signs of slowing demand for tech equipment as inventories have swelled in recent months. Yes, falling interest rates is good news for stock prices, but falling demand and revenues (if it happens) could more than offset those benefits. Though the Canadian economy remains strong, any sustained downturn in the US will eventually spill over here - especially the demand for technology equipment.

    As for the seasonal stock market anomalies, I don't put much faith in them. There are some anomalies that I take more seriously but this isn't one of them. Taking this a bit further, he fact that November to April has been a good period for a few years would, in my opinion, indicate that the likelihood of that pattern persisting for another year is low - especially in light of the economic numbers that have been released.

    Though I'm bullish on the economy and the stock market in general, I'm still somewhat pessimistic on the prospects for technology stocks as a group, over the next year or two. Don't get me wrong, I think technology has just begun to have its impact on all of our lives (both personal and business), but it's important for investors to remember that the price paid today has to have realistic expectations and a margin of safety built in. Otherwise, investors could be setting themselves up for disappointing results.

    For investment time horizons that exceed five years, some exposure to technology stocks is a decent idea. However, with the next year holding much uncertainty, it may be wise to build technology positions by averaging in - rather than plucking down a big pile of money all at once. I could be way out in left field but I still think a good amount of downside risk remains in the group of tech stocks. For investors that still crave growth stocks, take a look at financials (banks, insurers, etc.) and traditional defensive stocks like food and health care to balance out the overweighting in technology that remains in the portfolios of many investors.

    I wish all readers and site visitors a very safe and happy holiday season.

    Disclaimer

    This article is not intended to provide advice on, or promote, the investment merit of any individual equity securities. Before taking any action, investors should consult a qualified professional.

    Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com All stock price and valuation data is as of the close of business December 21, 2000.
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