In my last column, I wrote that technology stocks -- especially chip stocks -- would be a good place to have some money if economic growth is indeed slowing moderately. I even added another semiconductor stock,
, to a
Jubak's Picks portfolio already heavy with stocks from this sector.
But now, let's take my "What if?" scenario to its logical conclusion. Let's say that the Federal Reserve hasn't just succeeded in slowing the economy -- that Alan Greenspan & Co. have, in fact, stomped too hard on the brakes. Instead of reducing growth of the gross domestic product from as much as 6% or more to 3% or 3.5%, the Fed's actions slow growth to 1% or less. (Please remember that it's by no means certain that this is true. I'm just looking at all the possibilities here.)
How will technology stocks do then?
Look to Oil Stocks
Not so well, based on what may at first seem an obscure precedent. In fact, the tech sector then would likely be one of the hardest hit.
The precedent I have in mind is the performance of oil-drilling and service stocks in 1997 and 1998. To give credit where credit is due, I'm indebted to Christopher Wolfe, chief equity strategist for private clients at
, for this analogy. As odd as it may seem to compare these two sectors, I think Wolfe is right. The boom-to-bust history of the oil-drilling and service stocks in 1997 and 1998 does give technology investors a road map to use in charting the likely effects of any economic slowdown that takes growth sharply below 3%.
As bull market runs go, the boom in the oil-drilling sector from January 1995 through September 1997 was extremely impressive. A stock such as current Jubak's Pick
climbed by 880%, while the
moved up 106% and the
The subsequent decline, however, was just as sharp. From Oct. 1, 1997, to Feb. 28, 1999, Global Marine plunged by 77%. During that time, the S&P 500 rose 31% and the Nasdaq tacked on 35%.
The business story was pretty simple. With oil prices falling, oil companies reduced their expenditures for finding and producing new oil. The rates that drilling companies could charge for renting out their rigs fell as new orders started to dry up. Finally, with oil companies cutting their drilling budgets, the drilling companies found themselves with idle rigs. Revenues and earnings fell during this period. Earnings per share at Global Marine, for example, which had climbed from 31 cents in 1995 to $1.03 in 1996; to $1.79 in 1997; fell to $1.27 in 1998; and just 51 cents in 1999. Analysts project that the company will earn 60 cents this year as demand for rigs finally picks up again.
That story began to take a bite out of stock prices in the sector before revenue and earnings had hit their absolute peaks. In October through December of 1997, investors started to sell shares in anticipation of declining revenues. Speculation that the oil companies would cut their spending drove drillers' share prices down well before the budget cuts were actually announced. The logic -- that declining oil prices would mean reduced outlays to find and produce new oil -- was absolutely correct, even though some investors (including yours truly) postponed reaching this conclusion until the losses became impossible to ignore. (I hope I learned something from that. The tuition was certainly steep enough.)
Big Telecom Companies Drive Tech Sector
So how does all this apply to the technology sector in 2000? I'd cast the big telecommunications companies --
Qwest Communications International
and the like -- in the role of the oil producers in 1997. Their purchases of gear -- from optical fiber to wireless base stations to switches to routers to databases -- are the driving force in the technology sector right now. Sure, personal-computer makers are still buying chips and hard drives, businesses are buying software and consumers are purchasing DVD players. But the big bucks -- and the bucks that are relatively easy to track, since they're being spent by a small group of high-visibility players -- are coming from the buildout of the communications infrastructure and from the sale of the new services that infrastructure supports.
You can get a sense of the importance of this source of revenue by looking at the relative price-to-earnings ratios of stocks in different parts of the technology sector.
, which has relatively small exposure to the telecommunications buildout, certainly isn't cheap at a P/E ratio of 100. But compare that with
at a P/E of 125,
at 312, or
So far there's nothing in the numbers that shows a slowdown in business at the telecom giants -- or at their suppliers. At WorldCom, for example, revenue from data grew by 26% in the first quarter of 2000 over the first quarter of 1999. That's unchanged from the 26% growth racked up in the fourth quarter of 1999 over the year-earlier quarter. On the supply side, in recent weeks both SDL and Corning have announced that demand for their products is so hot that they'll easily crush Wall Street projections for the quarter that closes on June 30.
But that isn't stopping investors from worrying about the possibility of cutbacks. Look at what happened to
Applied Micro Circuits
this week, on the news that a decreasing percentage of sales would come from
, the company's biggest customer. Non-Nortel business more than picked up the slack, the company later noted, but the damage was done. From 122.63 a share on June 5, the day before the news, the stock fell to 90 a share on June 12.
I think there's just enough nervousness about the price of stocks in this sector, and the possibility of a slowdown, to produce a few more stunning declines like that suffered by Applied Micro Circuits. But without some numbers demonstrating that the telecom companies are thinking of cutting their spending, I don't expect a widespread decline in the sector.
The Standard: Accelerating Growth
I don't, at least, if I simply compare the conditions that led to the long-lasting drop in the oil-drilling sector with the state of the telecommunications-dependent technology sector right now. But there is an important difference that investors should factor in. The stock market has set a far higher bar for these companies than it did for the oil drillers. All companies in the drilling sector had to do was continue to show growing revenue and earnings in order to convince investors that the industry still dwelt in the boom part of its cycle. Technology companies supplying the telecom sector, on the other hand, have to show accelerating growth from quarter to quarter. With each earnings report, a Cisco or an SDL is under an obligation to grow earnings at a faster rate than it did in the previous quarter. It's that acceleration -- and that acceleration alone -- which justifies the astounding P/E ratios of these stocks in the mind of the market.
And that could mean trouble for those stocks in the third and fourth quarter of this year if economic growth slows to a rate below 3% to 3.5%. The same quarters in 1999 were boom times for these companies, Wolfe notes, and so it will be especially tough for the sector to show accelerating growth rates in the last half of 2000.
You can see the problem if you look at the numbers for some of the stocks in this sector on
under the Analyst Info tab. For example, analysts are projecting that Broadcom will grow earnings by 55% in the third quarter and 73% in the fourth quarter from the year-earlier periods. But that will still be down from the 97% growth analysts project that the company will report in the current quarter over the year-earlier period. Cisco shows the same pattern: 42% growth projected in the current quarter and
32% projected for the October quarter.
Projections like those make me nervous about this sector. That slowdown from hypergrowth to merely outstanding growth could, by itself, cause temporary volatility and some unexpected price declines in high-priced technology stocks during that period. And the possibility that the economy could slow more quickly than expected in the months ahead could magnify that volatility.
Investors should pay close attention to next month's financial reports, covering the current quarter, to see if there are any signs of slowing orders by any of the telecommunications giants, and to see if any of the telecom technology providers are straining to make their numbers. Quality of earnings will count. You can be sure that analysts will be looking to see if any company is using one-time gains to disguise a deceleration in earnings growth from operations. And you should, too.
The end of summer, it seems to me, isn't going to mean the end of volatility for this market.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Broadcom, Cisco Systems, Commerce One, Global Marine, Network Appliance, Nortel, RF Micro Devices, Wind River Systems and WorldCom. He welcomes your feedback at
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