Rising Rates Rank Low on List of Tech Stock Worries

Next week, we'll all be adjusting to life with higher interest rates, if the Federal Reserve Board does what's expected on Tuesday and raises rates a quarter- or half-point. Anyone house-shopping this weekend should stop reading now and close a deal before mortgage rates creep any higher. For the rest of us, it might be a good time to examine one of the new era's tenets, the one that says technology stocks are immune to higher rates.

Two months ago, Wall Street sages were arguing that tech-stock investors didn't have to worry about higher rates. Tech companies carried little if any debt on their balance sheets. Capital came from the equity markets, not the corner bank. And if inflation forced the Fed into ratcheting rates higher to slow the economy, what did tech companies care? Their customers couldn't afford to put off the productivity gains that investing in new technology brings. Tech, it seemed, was the new defensive play.

We now know that tech is definitely not defensive, as the 33% decline in the Nasdaq Composite Index or the nearly 50% decline in Internet stocks since March 10 demonstrate.

But you can still argue pretty persuasively that tech stocks, if not immune, are still relatively insensitive to interest rates.

Let's start with some Finance 101. The more you're being paid to hold cash or Treasury bonds in the here and now, the less attractive a company's future earnings become in comparison. That's especially true if rates are rising because of inflation, which erodes the value of those earnings. Also, the odds are, if rates are rising, the economy is slowing, and along with it, the growth rate of earnings -- again, making them less valuable now. No wonder the price part of price-to-earnings ratio crumbles and multiples contract, when interest rates are rising.

That's what happened in 1994, the last time the Fed got aggressive about raising rates. From its March 18 high through June 24, the Nasdaq fell 14%, while the Nasdaq P/E fell from a high of 44.8 in February to 37.5 in June. "Rising rates are a death knell for extensive overvaluation," says Jim Stack of InvesTech Research. (Later in 1994, P/Es fell still further, but that was because earnings rose.)

A closer look at what's been going on since the Fed began tightening last June, however, shows a different picture. The S&P 500 index has returned 4.5% since Greenspan & Co. started tightening the screws. But if you take out tech stocks, the index has actually fallen 6%. And while the S&P 500's P/E is down from a peak of 26 last April to about 23 today, the P/E for the tech component of the S&P 500 has risen from 37 to 40. So while last year tech stocks were selling at 1.42 times the market multiple, now they're selling at a richer 1.67 times. Yes, higher rates will put pressure on P/Es. But so far anyway, there's been no collapse.

And if the table below is any indication, tech-stock investors have little to worry about next week -- if anything, they should load up on some of the Nasdaq's finest. Since June, the Nasdaq has risen 37%. But if you take just the gains logged during each of the seven weeks that the Fed's Open Market Committee met, you've got a compound gain of 47.5%.

FOMC Meeting	Fed Action	Nasdaq Gain for the Week
June 30, 1999	Fed Funds up 0.25%	7.4%
Aug. 24, 1999	Fed Funds, Discount Rate up 0.25%	4.2%
Oct. 5, 1999	Tightening bias	5.5%
Nov. 16, 1999	Fed Funds, Discount Rate up 0.25%	4.6%
Dec. 21, 1999	No action	5.8%
Feb. 2, 2000	Fed Funds, Discount Rate up 0.25%	9.2%
March 21, 2000	Fed Funds, Discount Rate up 0.25%	3.4%
Source: InvesTech Research

One reason tech stocks might be better able to withstand higher rates than the market overall is that nearly half or 47% of the tech industry's sales come from outside the U.S. "They're not hostage to the local economy or the local central bank," says Lehman Brothers strategist and chief tech-stock cheerleader Jeffrey Applegate.

Not being hostage to the economy is a recurrent theme, encompassing the belief that customers will stop spending on just about everything else before they stop spending on technology. "Tech companies have a product their customers don't buy based on the economy or interest rates," says Jim Bianco of Bianco Research in Barrington, Ill. "Yes, Cisco (CSCO) is selling routers to GM (GM) and to electric utilities. But they have to stay up-to-date too."

Jim Paulsen, chief investment officer at Wells Capital Management in Minnapolis makes a distinction between the Ciscos, Intels (INTC), Sun Microsystems (SUNW) and IBMs (IBM) of the world and the small-cap, dot-com wonders that rode to riches on streets paved with venture-capital and IPO gold. Hostage to the economy? The dot-coms are barely even part of it.

What economic realities were reflected in their infinite P/Es or the no-cost capital that financed everything from labor costs to restaurant bills? Now that the spigot is shut off, don't extrapolate any larger economic truths from the bankruptcies and liquidations sure to follow, says Paulsen. "What's happening there is unrelated to the economy. They were in a world of their own on the way up, and they will be, on the way down."

In other words, there might be plenty to worry about when it comes to tech stocks, and more to worry about with some than with others. But interest rates aren't at the top of the list.

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