What Goes Down Must Come Back Up

Few investors still believe that New Economy stocks are immune to cyclical forces, especially not after the drubbing they've taken in recent months.

It is now clear that stratospheric growth rates don't inoculate New Economy stocks from Old Economy slowdowns, and that interest rates matter after all, even if start-ups don't rely on borrowing to fund their capital needs.

But this is good news, even if it doesn't look like it. To understand why, we need to examine the pattern of the decline in New Economy stock prices here and abroad.

A look at the chart below, showing the Nasdaq, Germany's Neuer Markt index of New Economy stocks and TheStreet.com Internet Sector index, or DOT, reveals a distinctive pattern. Last spring, the prices of New Economy stocks plunged, not just in the U.S., but also in Europe and elsewhere. After leveling off during the summer, those prices are dropping again this fall. In effect, the stocks have suffered a one-two punch.

Temperature Gauges of the New Economy The Nasdaq, the DOT and the Neuer Market

Last spring, growth was strong and inflation pressures were rising rapidly, with ECRI's Future Inflation Gauge already at an 11-year high. The resultant rise in interest rates was a major negative for the prices of many New Economy stocks. (Click here for a chart of the FIG)

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Why? Because stock prices are a measure of discounted future earnings, and the discount rate depends on the interest rate. Since many New Economy firms expected to become profitable only after several years, the discount factor reflected the interest rate compounded over many years. Thus, stocks with distant profit prospects were especially vulnerable to higher interest rates, which effectively slashed the net present value of future earnings of such firms.

Prices stabilized over the summer as interest-rate fears receded. However, the inevitable lagged effect of worldwide interest-rate hikes started showing up this fall as signs of a global economic slowdown. This slowdown was aggravated by the effects of higher oil prices, which acted as a tax on both producers and consumers. As I pointed out shortly after Labor Day ( Call It the Oil Recession ), the rise in oil prices significantly raised recession risks.

The current slowdown has squeezed the profits of the clients of many New Economy firms. And when profits come under pressure, discretionary expenditures are the first to go.

Thus, advertising, the lifeblood of most Internet companies, came under pressure. Capital expenditures, which are very sensitive to profits, were also reduced or postponed in many cases. With information technology (IT) now accounting for 60% of capital expenditures, it was inevitable that IT stocks would feel most of the pain. It is this earnings hit that is responsible for the second leg of the decline in New Economy stock prices that we are now witnessing.

Recession risks remain significant, particularly if oil prices spike again. Also, the slowdown in Europe and America severely damages the prospects for what used to be called the Asian Tigers (Hong Kong, Singapore, et al), whose recent recoveries from deep recessions were driven by exports.

It is precisely when worldwide growth is slowing in this fashion that the resultant stresses are most likely to trigger crises, whether in Asia or Latin America or elsewhere. To the extent that such a crisis can trigger a global recession, there is a chance that the prices of New Economy stocks will fall even further.

OK, we've heard the bad news -- what is the good news? Click here to read Part 2.

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Anirvan Banerji is the director of research for the Economic Cycle Research Institute , which was founded by Dr. Geoffrey H. Moore, creator of the original index of leading economic indicators (LEI) for the U.S. Department of Commerce. Banerji is on the economic advisory panel for New York City, and is also a member of the OECD Expert Group on Leading Indicators. At time of publication, neither Banerji nor his firm held positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Banerji cannot provide investment advice or recommendations, he welcomes your feedback at Anirvan Banerji .