The recent explosive gains in technology stocks have sent prices into orbit.

SDL

(SDLI)

, for example, has almost doubled since the beginning of the year, climbing to 410 on Feb. 29 from 218 on Dec. 31. The stock is up 58% in the last month.

RF Micro Devices

(RFMD)

is up 71% in the last month,

BroadVision

(BVSN) - Get Report

up 95%,

GlobeSpan

(GSPN)

up 105% and

PMC-Sierra

(PMCS)

up 113%. None of these stocks was exactly cheap to start with, either.

In an ordinary market, I'd say these kinds of gains aren't sustainable. These stocks are headed for a very sharp fall in relatively quick order, I'd comment. This kind of takeoff from already heady levels is a classic blowoff, a last gasp before a big decline, I'd add.

Maybe that's the case. But as this very extraordinary market has taught me over and over again, it pays to consider all the possibilities -- even those that would be extremely unlikely in an ordinary market.

Recently, I've begun to see evidence that this huge appreciation in the prices of technology stocks may not be the prelude to some wrenching correction in the next month or two. Indeed, contrary to conventional wisdom, I think the climb in the prices of technology shares may be making them less risky in the short term. And the climb could make any March dip in technology-stock prices caused by worries over what the

Federal Reserve

will do at its March 21 meeting of very short duration.

How do I know? Money flows tell me so.

Bad Market for Old Economy

If this were an ordinary market, I'd say it was deep into the danger zone. In recent weeks, we've witnessed an incredible divergence between the Old Economy stocks that make up the

Dow Jones Industrial Average

and the

S&P 500

, and the New Economy stocks that dominate the

Nasdaq Composite

index. Even with the rallies early this week, the Dow was down 11% for the year as of the close Feb. 29. The S&P was down 6%. But the Nasdaq was up 14%.

The divergence looks even worse if you examine indices that don't include any of the nontechnology distractions of the Nasdaq. The

Philadelphia Semiconductor

index was up 64% for the year as of Feb. 29, and the

biotechnology

index trailed only moderately behind, with a 45% gain for the year to date.

It's not hard to explain this divergence. This type of market occurs pretty frequently when the Fed signals its determination to hike interest rates. The stocks of the Old Economy (the shares of companies engaged in such businesses as retailing, banking, drug manufacturing and aviation) carry significant loads of debt, and rising interest rates make borrowing more expensive. More significantly, if the Fed's actions succeed in slowing an economy that grew at an annual rate of almost 7% in the fourth quarter of 1999, growth will be particularly affected at these companies, whose fortunes are most closely tied to expansion of the economy as a whole. It's hard to see more people rushing to buy cars, for example, if car loans cost more and if the number of unemployed workers edges even slightly higher. Under the circumstances, shares of

Ford Motor

(F) - Get Report

, just to pick a random, well-managed, Old Economy company, ought to go down. And they have -- 19% for the year to date.

Precedent for Tech Stocks' Breakout

Frequently at this stage, a group of especially fast-growing stocks -- technology now; big consumer-goods companies in 1972 -- will avoid the general decline and break out, heading for new highs. The companies behind these stocks are usually growing far faster than the economy as a whole -- 40%, 50% or sometimes much more each year -- and that growth rate seems independent of the economy as a whole. These stocks seem able to simply outgrow the consequences of any interest-rate increases.

For a while -- perhaps a good while -- this theory will seem to be true. These stocks go up day after day, while the rest of the market stagnates or even drops. But each day, the advance gets more difficult to sustain. The group as a whole gets more expensive each day, both absolutely and relative to the stocks in the depressed sector of the market. Then, one stock or another drops out of the group after a warning of slower growth. Investors who witness the punishment meted out to that stock get increasingly nervous about the highfliers they still own. Maybe they decide to take some profits.

And then one day, something triggers the collapse of the group. Perhaps an event in a market halfway around the world makes U.S. investors head for the safety of cash. Perhaps prices in the beaten-up sector of the market simply start to seem too attractive, and money begins to flow out of highfliers and into the laggards. Whatever the reason, the rally among the winners ends, resulting in either a general market decline or a rotation out of these stocks and into bargains.

Rout Isn't Certain This Time

That, at least, is what usually happens. And it could happen this time, too. But, because of the peculiar structure of the current market, the rout of the highfliers isn't absolutely certain, and at a minimum, I believe it's at least a month or two further out than the traditional scenario suggests.

What's different this time? Even before the Fed announced its intentions, we were in the middle of a huge rotation away from the growth stocks of the Old Economy and toward the technology growth stocks of the New Economy.

You can see it in the money flows into mutual funds. According to the

Investment Company Institute

, the mutual-fund industry's trade group, and firms such as

AMG

that track fund flows, money this year has been moving out of value funds, balanced funds, index funds and blue-chip growth funds, and into aggressive growth and technology funds. The shift is even bigger than the raw numbers show, since many value- and balanced-fund managers have been adding technology stocks to their portfolios in an effort to keep up with the Nasdaq. That index, and not the S&P, has become the new benchmark.

You don't need to look any further than 1999 to see the reason for the change. The S&P 500 had a pretty good year, returning 19.26%. But after many years of trailing the index, a full 26% of the 9,419 mutual funds in the MSN MoneyCentral Finder database beat it last year.

Meanwhile, the Nasdaq returned a huge 84.11% in 1999, beating the traditional benchmark index for the second year in a row. (In 1998, the Nasdaq gained 40.11%, while the S&P scored 26.67%.) A pitifully small 4% of fund managers -- 356 out of 9,419 funds -- beat the Nasdaq benchmark last year.

Following the Money Flow

So managers have done what any rational investor would do under the circumstances: They've gone where the money is. And there, in the technology sector, they've encountered all the individual investors who have reached the same conclusion.

Nothing has happened so far this year to convince anyone that stuffing a portfolio as full of technology stocks as you can isn't still the best strategy. Mutual-fund managers are again trailing the Nasdaq's gain in 2000 -- only 18 funds out of 9,419 have beat it year to date.

So what does an investor -- or a fund manager -- do now? Well, some are biting the bullet and buying the stocks that are going up, no matter what the price. It's this money -- some of it the big seasonal flow from end-of-the-year contributions to 401(k) plans -- that has enabled the technology sector to thumb its nose at any potential moves by the Fed.

Some investors, however, have balked at the price of entry. They've watched with itchy fingers as RF Micro Devices, for example, moved from 90, where it seemed just a bit too expensive to buy, to 138, where it seems just incredibly expensive. This money is sitting on the sidelines at the moment, waiting to move out of cash or, maybe, out of laggard blue-chip growth stocks.

Flow May Extend the Tech Rally

Why is all this money flow important? And what does it mean for how the market will play out?

  • First, there is some chance that money flows into technology stocks and out of other sectors will be enough to keep the technology rally going right through the Fed's March 21 meeting. If that happens, tech stocks could well rally all the way into earnings season in April. I'd say this is possible, but not likely. The evidence so far in 2000 is that the intense worries about interest rates peak in the two to three weeks before the Fed meets, and are strong enough to take down tech stocks, too. I'd say the chance that technology stocks will have clear sailing into April is about one in three. Not small enough to ignore, but not enough to bet the farm on, either.
  • Second, there's a very good chance that the money now on the sidelines waiting for any break in technology prices would rush in very quickly on a decent dip. RF Micro Devices at 120 would look very attractive to frustrated investors who've missed some of the action. The likelihood, therefore, is that any March dip will be limited and short. Maybe something like those two-to-three-day "corrections" the market went through in January. Blink and you might miss it. I'd say that the chances any pullback will be short and none too deep are around two in three.

No dead certainty in any of this, of course. This market has shown repeatedly the capacity to zig when I supposed it would zag this year. But this handicapping does suggest how to position a portfolio to maximize your chances of profiting from the most likely scenarios. No need to move everything to cash. The likelihood of a big correction in March or April -- lots of points and more than two weeks in duration -- is pretty small, I believe. It would be smart, however, to have some cash to exploit a short drop, or just in case the decline is deeper than I expect. And it's wise to hold most of your positions. That way, you'll be ready to take advantage of the possibility of a continued run into April, or be in good shape to ride out a relatively mild pullback. That's about the position of

Jubak's Picks right now. I'm holding 21 stocks, four below the 25 limit that counts as fully invested for this portfolio. That's roughly equivalent to a 16% cash position.

I think this counts as a fine-tuning of the strategy and market scenario I laid out in my Feb. 4 column,

Finding the Upside in an Up-and-Down Market. I still think we're likely to see tremendous volatility in stock prices this year. We could still see a spectacular bout of volatility in the period from March 1 to March 21, leading up to the Fed meeting, as I wrote in that column. But I now think that's less likely than I thought then. The overall market will fall, I believe, but the technology sector might escape with only a quick dip, and then rally into April's earnings season.

That would just increase the potential volatility after earnings season, as technology stocks head into their traditional summer slump. The May 16 Fed meeting, combined with that seasonal weakness, could spell real trouble for technology stocks if they've managed to escape any meaningful correction before then. And absent a March correction, I'll almost certainly be raising my cash level as we go into that period.

As always, though, stay tuned for further adjustments. This isn't a market that treats long-term predictions very gently.

Jim Jubak is senior markets editor for MSN MoneyCentral. At time of publication, he was long BroadVision, Citrix Systems, LSI Logic, National Semiconductor, RF Micro Devices, SDL and Vitesse Semiconductor, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. He welcomes your feedback at

mctsc@microsoft.com.

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