Approaching Bear Market,
Techs May Fall Still Farther
August 14, 2004 7:08 a.m.
Tech investors are feeling the bear's breath on the backs of their necks, but with many on Wall Street saying stocks are cheap -- but not cheap enough -- that breath may only get hotter.
The Nasdaq Composite Index is off 18.4% since its peak in January, nearing the 20% drop that would put it in bear-market territory.
"Valuations are lower than they were but they're not compelling," says UBS technology strategist Pip Coburn, who thinks tech stocks will be able to rally only once investors stop viewing them as a hot commodity and price-earnings ratios become more reasonable.
The Nasdaq ended Friday at 1757.22, down 12.3% for 2004. Where will it end the year? Vote in the Question of the Day.
Go Figure: Technology funds have taken a beating this year. Is it time to reconsider their place in your portfolio?
Here's how he sees it: In 1994, when tech was "nothing special," tech stocks traded in a range of 15-25 times earnings, he says; right now, they stand at about 24 times forward earnings, using the Dow Jones Global Tech Index and UBS's own tech indexes. He predicts price-to-earning ratios for tech stocks will keep falling since investors feel shaky about the decline in growth of future earnings.
"People aren't going to buy tech stocks if they think estimates are going to keep coming down; you don't buy when estimates collapse, because when they collapse they really collapse," he says. "You thought you were paying 24 times earnings, but you were really paying 40 times earnings."
He thinks tech prices will bring those ratios down toward 18 times earnings in the coming year, and sees valuations getting tempting at around 16 times earnings. "I think that's when we'll see Warren Buffett get in the game," he says.
There are still those on Wall Street who thinks techs will fare fine this year. Some expect capital spending to leap in the fourth quarter as the outcome of the election becomes clearer and companies rush to take advantage of special tax breaks regarding tech spending that expire in 2004. Others point out that its unfair -- and unwise -- to look at all tech companies as being equal. Some sectors and firms will weather the downturn more easily, while others will suffer as investors spurn them.
But for now, analysts who crunch the numbers and make the charts on Wall Street also think the rout in the Nasdaq isn't over yet.
"No doubt we're oversold. The problem with oversold markets is they can become more oversold," says Price Headley, technical analyst and president of BigTrends.com in Lexington, Ky. "When you're in a free-falling type of market, you have to wait to see a true extreme of fear before you get a bottom."
See a calendar of earnings reports scheduled for the coming week.
See a calendar of economic reports scheduled for the coming week.
Mr. Headley once thought that point came earlier this month, when the broader market saw a big selloff following a much weaker-than-expected jobs report. The CBOE equity options put/call ratio rose to 1.27, which he called a "high fear reading."
High put/call ratios -- the volume of puts divided by the number of calls -- indicate that many investors are either hedging current investments against a decline in prices or speculating that a particular stock will decline. Puts give investors the right to sell at a certain price, while calls give them the right to buy.
"It's a sign of panic -- you're getting a rush of people realizing how bad the market looks, speculating and buying puts or hedging portfolios against the down markets," says Mr. Headley. "By the time everyone realizes that it's usually an inflection point where the market is seeing a washout phase as long as the lows hold there. Which they didn't."
Instead, tech stocks kept dropping last week, hitting new lows for the year. The Nasdaq ended the week down 1.1%. Mr. Headley thinks a realistic target for a short-term bottom in the Nasdaq is around 1640 to 1600 -- another 6.7% to 8.9% drop from current levels. That would leave it down 24% to nearly 26% from its January peak.
Though earnings outlooks for the sector for the remainder of the year are promising, they're probably not promising enough. According to Thomson First Call, earnings growth in the third and fourth quarters for tech stocks is expected to hit 35% and 20%. While double-digit increases are no small potatoes, they're no match for the estimated 66% profits growth techs racked up in the second quarter. "Deceleration" has become a buzzword among tech analysts, and it's one of the concerns that plagues investors, especially when they're eyeing valuations that are nowhere near bargain basement.
Queasiness over deceleration in earnings growth was a repeated theme during earnings season, leaving technology stocks vulnerable. Though some outfits, like Dell and IBM, for example, have reported continued growth, Cisco Systems warned that it is taking a cautious view of tech spending, given tepid feedback on hopes for the economy from CEOs of other tech companies. Thursday, Hewlett-Packard said its current quarter would fall short of Wall Street expectations, further disappointing investors.
But the real surprise has been that things aren't getting better going into the second half. Summer is seasonally weak for tech sales, but the expectation was that things would pick up later in the year. Some expect this more modest growth will be the norm for awhile.
Steve Milunovich, Merrill Lynch's global technology strategist, says that typically there are three stages in the recovery from a bubble. The first wave is the bust, when stocks tumble. In the second wave, stocks recover a portion of those losses, though not all – that happened last year. And during the third wave, which some theorize we're in, stocks get into a two-steps forward, one-step back pattern (or depending on the year, the other way around.)
"In the third wave, you can test the lows, but you go into a long-term trading range, which can be multi-year," he says. "Looking out three years, I start to get bullish on technology, but our view is that we're in that transition after the bubble."
Write to Erin Schulte at erin.schulte@wsj.com
