If you're hunting for surefire picks that will gain from the Fed's rate cut, the first place to look shouldn't be technology.
Stock market history shows that none of the bread-and-butter technology sectors -- PCs, software, communications equipment, semiconductors -- were among the top five performers for either the three- or six-month periods after the Federal Reserve starts cutting interest rates.
But it's important to note that none of these bread-and-butter technology sectors make the lists of worst-performing stock sectors -- bottom-five performers such as telephone stocks or electric utilities.
So if key technology sectors aren't superstars or dogs, what are they?
Call them slow starters -- stocks that turn on the gas after the race is a few laps old. And that pattern should form the basis of your investment strategy for this sector in 2001.
Take the semiconductor sector. Chip stocks, that is. The group barely makes
list of the top 10 performing sectors in the three months after an interest-rate cut, coming in at No. 10. That's behind such flashy sectors as drugstores (No. 7) and footwear (No. 9).
But then take a gander at the list three months later. The semiconductor group has climbed over drugstores and entertainment to take over the No. 6 slot. Over the even-longer haul -- that is, from the initial interest-rate cut to the first, subsequent interest-rate hike -- the semiconductor group climbs to No. 5. And the computer software and services sector comes out of nowhere to take the No. 4 position.
Why Debt Is Key
I think there is a good, common sense explanation for this pattern. The stock groups that respond most quickly to a Federal Reserve interest-rate cut are those with big, direct exposure to interest rates and those that operate predominantly in the consumer rather than corporate market.
Stock groups with big direct exposure to a drop in interest rates include financial firms; banks can make money from the decline in what it costs them to borrow the short-term money they use to make long-term loans. And this category also includes the stocks of companies with huge debt loads and big appetites for future borrowing. For example, telecommunications companies such as
Metromedia Fiber Network
Level 3 Communications
, which are all still building their networks with borrowed money, fit this description to a T.
The stocks have therefore rallied dramatically so far in January. As I write this, Global Crossing is up 56% for the month, Metromedia Fiber is up 55%, XO Communications is up 44%, and Level 3 is up 36%. (Of course, rosy forecasts of revenue growth for 2001 from Global Crossing and Metromedia Fiber haven't exactly hurt.)
Stocks groups with big exposure to the consumer market include retailers, hotel operators, homebuilders and entertainment companies. So it's not particularly surprising that these sectors should jump out of the gate when interest rates start to fall and the prospects for future economic growth improve.
Technology stocks, by and large, don't match up very well with either of these explanations. Technology companies raise capital in the stock market, for the most part, so they're generally not big borrowers. And they don't carry huge debt loads. (Next-generation telecommunications service companies are the obvious exception.)
, for example, carries a tiny 0.02 debt-to-equity ratio. Compare that with
1.59 ratio. Neither are technology companies in the business of lending money, so they can't profit from changes in the cost of short-term borrowing.
As a whole, too, the companies in the technology sector have more exposure to the corporate market than do consumer companies such as
. Computer software and hardware companies such as
, the parent of
sell both to consumers and to corporations. And technology groups like the semiconductor sector that include relatively pure consumer plays such as graphics chipmaker
, also include predominantly corporate-market companies such as
Consumers Respond to Rate Cuts
That's important, because consumers are more inclined to increase their purchasing immediately after an interest-rate cut than are corporate CEOs. Consumer spending decisions don't require massive budget reviews and collective decision-making by dozens of department heads. By and large, consumers don't rigidly follow spending plans set out a year in advance before buying a pair of shoes or taking a three-day weekend trip. Consumer spending both falls and rises faster than corporate outlays in response to the prevailing hopes and fears for the economy in the future. That's why consumer-oriented stocks are hammered first when fears of a recession set in and why they rebound fastest when those fears start to recede.
Many consumer-oriented stocks already have been through the warning-estimate-cut-rating-downgrade cycle. And the prices of these stocks fell late last year in anticipation of bad earnings and revenue reports for the fourth quarter of 2000 and the first half of 2001.
Technology stocks have certainly been crushed in price, but many are still only partway through the same warning-estimate cut-downgrade cycle. We already have a pretty good idea of how much money consumers spent -- or didn't spend -- during the holiday shopping season. But key, well-managed technology companies such as Intel and Microsoft told analysts in December that they have only very limited ability to forecast revenue for the first quarter of 2001. No one will have a good handle on cuts in corporate budgets for information technology -- networking gear, PCs and software -- until sometime toward the end of this month.
Why It Matters to Investors
So what does all this suggest about how and when to invest in technology stocks?
First, because neither the technology sector as a whole nor key subgroups such as semiconductors and software get out of the gate with the rabbits, there's little risk of waiting a month or two before buying these stocks. If this market follows the historical pattern, technology stocks will follow, not lead, in any post-rate cut move up by the market.
Second, waiting also makes sense because technology stocks haven't yet completed their bad-news cycle. After all the earnings warnings and preannouncements of the last month or so, I doubt that many companies will actually miss earnings forecasts when they officially report fourth-quarter 2000 results in the next few weeks. But many of these companies have been stubbornly sticking to their past forecasts for growth in 2001, and analysts and investors will be watching intently to see if CEOs lower their guidance for the coming year. Lower guidance -- a forecast, say, of 20% growth instead of 25% growth -- will do significant damage, even to a stock that's already down 50% from its high. I think this makes the next month a potentially risky one for investors in technology stocks. The probability that a stock will blow up after a CEO lowers guidance is relatively high.
Three, this suggests that the passing of this earnings season in early February will significantly lower the risk in many technology stocks. A company that has lowered guidance once, can, of course, lower it again in the future. But the odds that a well-managed company will miss its forecasts badly twice in quick succession are relatively low. Certainly all the risk won't be out of technology stocks by mid-February -- not when the possibility of a true recession still lingers. But revenue and earnings visibility should improve for many of these companies as 2001 progresses, and better visibility decreases the possibility of negative surprises.
Four, among technology sectors and individual stocks, it makes sense to invest in consumer-oriented companies before those that sell predominantly to the corporate market. For example, I think a chipmaker such as Atmel , whose products go into such consumer goods as DVD players, digital cameras and cell phones, is likely to respond more quickly to the Fed's interest-rate cuts than a chipmaker such as PMC-Sierra, whose products go into networking gear sold to corporate customers by Cisco Systems and Lucent Technologies , among others.
Fifth, the last technology stocks to respond to the positive influence of Fed rate cuts are likely to be the capital-equipment companies such as Cisco, Lucent, Nortel Networks , and Corning . The bad news from customers, if any, is still in the pipeline for companies like these.
Specifically, here's what I'm going to be doing in Jubak's Picks based on this analysis. I'm going to take a careful look at the corporate-oriented technology stocks that I now own, such as
and PMC-Sierra, to estimate the potential downside still in the customer pipeline. I want to understand both my current risk in each stock as well as the potential reward, and how long the stock might be dead money. Frankly, the two that concern me most at this point are Ariba and PMC-Sierra; I think they have a relatively high probability of lowering future guidance when they report and look to be the two that could lag in a recovery. Any quick bounce in either of these issues -- which would reduce the potential future upside -- deserves careful consideration as a potential exit.
Don't Give Up on Tech
I'm certainly not abandoning the technology sector. Long term, I think it continues to offer the best potential returns for investors of all market groups, but I am going to hold off on any new technology buys until after the company has reported and issued new guidance for 2001. In the case of any stock that still looks attractive after it has reported, I'm going to play it extra safe and give the analysts a few days to pick through the numbers. In a market like this, investors can turn even the slightest flaw into a major drop in the stock's price. So I think it's just prudent to let the dust settle.
I'm going to concentrate my first new technology picks among consumer-oriented technology companies and hold off on networking and Internet-infrastructure stocks until later in the cycle. Ideally, I'd like to wait until February or later to put new money to work in the technology group -- I think that schedule would do the best job of reducing risk -- but I'll also be watching the Fed carefully. If
& Co. decide to cut rates by another 50 basis points at the Jan. 30-31
Federal Open Market Committee
meeting, I might decide to speed up my schedule.
Within this strategy, what are examples of the kinds of early technology movers I'll be looking at? Current Jubak's Picks Atmel,
and Nvidia fit the bill. New stocks that I'd put on a consumer-technology Watch List include
, a player in the fast-growing market for Read/Write CD drives,
, a big maker of flash-memory storage for MP3 players, digital cameras and digital camcorders, and
, the maker of the new PlayStation 2 game console and one of the world's dominant entertainment companies as well.
No buys yet, mind you. I still think this is a time for crunching numbers and comparing stocks. But with the Fed on the move, I can now foresee a time when buying technology stocks will again make sense.
And another bit of history suggests this timing is about right. Historically, the first month after the Fed begins to cut interest rates is full of uncertain moves that often don't add up to much. The market doesn't really move upward until after the second cut. That could come at the Jan. 30-31 meeting.
Wouldn't hurt to be ready.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Applied Materials, Ariba, Atmel, BroadVision, Cisco Systems, Global Crossing, GlobeSpan, Intel, LSI Logic, Metromedia Fiber Network, Nvidia, Nokia and PMC-Sierra.