Tech Stocks Having a Jolly January, but Can This Month's Rally Continue?

An economic recovery is priced into this rally. The Fed better get busy.
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The first month of the year hasn't been all tech, all the time, but at least it hasn't been no tech, no way, no how.

Technology stocks, the scourge of the market during the second half of 2000, have reassumed something of a leadership role in the market this month, motivated by fresh cash inflows into mutual funds and the

Federal Reserve's surprise 50-basis-point interest-rate cut on Jan. 3. Between Jan. 1 and Friday, the

Nasdaq Composite Index was up 12.1%, and market internals have been strong most days.

Strategists, however, expect a bit of selling, similar to what's happened in the last two days, in February and March. Overall, people in the investment community believe that the economic environment should improve six to nine months down the road. But the extent to which companies are able to improve in tandem is unknown.

"We have to accept that this is not a soft landing; it's bordering on a potential recession and all eyes are on the eventual recovery," says Barry Hyman, chief investment strategist at

Weatherly Securities

. "The only question now is, how aggressive should the market act in anticipation of that, or in dramatic advance of that? That's the problem; how high the market should go in the short term."

The recent rally in the market was partially due to the unleashing of pent-up cash sitting on the sidelines, both in the accounts of individuals and in various types of funds. After Jan. 1, folks no longer encumbered by year-end tax-loss issues or the prospect of augmenting their already lousy performance for the year could buy technology stocks unfettered.

That tendency was propelled further by the Fed, which responded to signs of sharp deterioration in the economy by cutting interest rates by the 50 points. The markets reacted strongly, extrapolating from this action that the Fed soon would reduce interest rates further, which in turn would loosen credit, make borrowing easier and boost demand, which would improve earnings.

By and large, strategists don't seem too surprised over this rally -- because the stock market discounts future economic activity. However, with economic recovery all but assumed, market analysts now believe the future of stock market gains depends on how forcefully the various companies respond in terms of seeing demand rebound and earnings strengthen.

"What's going to be tested now is how much staying power" this rally has, says Rob Cummisford, portfolio manager at

Kent Funds

in Grand Rapids, Mich. "That'll be when we start seeing negative-type announcements out of next quarter's earnings and the earnings outlooks."

Indeed, with the Fed now moving into the plus column in terms of the various factors working for or against the market, the onus for continued improvement in the stock market will, at some point, shift to recognition that specific company fundamentals have hit bottom, and are beginning to improve.

So far, that hasn't happened. Earnings tracker

I/B/E/S

noted this morning in a comment that 2001 growth expectations for companies in the

S&P Technology

sector have dropped to 5.5% year over year from 13.6% just one month ago. If the earnings malaise plagues the market for another couple of quarters, the improved sentiment, mostly hung on the anticipation of more rate cuts, will sour.

Those at

Morgan Stanley Dean Witter

believe the information technology sector is hitting its first-ever recession, projecting that IT growth rates will fall to zero in the third quarter from 23% in the third quarter of 2000.

"For a U.S. economy that has derived 20% to 30% of its total growth from surging IT over the past four years, such a growth compression could come as a real shock," wrote Morgan Stanley's chief economist Stephen Roach, on Friday.

Different Recoveries

The recovery, when it happens, may not benefit all companies

equally. Market psychology remains a bit shaky, according to investors. The surprise rate cut, and the anticipation of more easings, which has driven the market, won't quite be the motivating factor anymore. "The logic is, we're still anticipating the worst, until companies come out and say otherwise," says Brian Gilmartin, portfolio manager at

Trinity Asset Management

.

Once evidence emerges that economic recovery is being felt by the various technology companies, then tech might truly take off again. Companies that don't improve won't be part of the rally -- which is sort of like it was in 1998.