TechWeek: The Market Had It Right

Maybe there was a reason to sell tech this spring after all.

When investors sold off tech stocks earlier this year, the mass exodus didn't seem to have much rhyme or reason to it. Share prices dropped right and left, seemingly with little regard to the particular company involved. As long as the company was in the broader tech sector, it got sold.

So investors sold Apple ( AAPL) along with Dell ( DELL), despite different results and prospects. They sold Advanced Micro Devices ( AMD) along with Intel ( INTC), even though the former had been gaining share on the latter.

The overall impact could be measured by the indices. From late April through this week, the tech-heavy Nasdaq Composite, TheStreet.com's Internet index and the Goldman Sachs Software index were all down 10% or more, while the Philadelphia Semiconductor Sector Index was down 23%.

Not that there weren't reasons investors could point to for the selloff. The tech sector had a strong run for the previous 18 months or so, and it was likely due for a correction. Interest rates were rising, as were oil prices, while home sales were starting to slacken. Investors worried about what that combination might do to consumer spending.

The backdating scandal, which has largely focused on technology companies, was starting to gain momentum about the same time. And a number of tech blue chips warned of disappointing results.

But at the time, those looked more like excuses to sell than real concerns. The macroeconomic worries, for instance, had implications for the entire market, which also had benefited from the same rally that tech stocks saw. Yet techs felt the brunt of investors' fears, seeing a much steeper decline than the market as a whole.

While the backdating scandal certainly didn't help the tech sector, the selloff was already in full swing by the time that issue became widespread. And investors didn't just sell a few underperforming tech companies; they basically threw out the good with the bad.

Hindsight is 20/20, of course, but given the recent earnings reports and news out of the tech sector, the selloff is starting to make a little more sense. Indeed, the market is starting to appear to have been more prescient than panicked.

First off, the macroenvironment has arguably worsened since this spring. On Friday, for instance, the Commerce Department reported that the U.S. economy slowed markedly in the second quarter after growing at a torrid pace earlier in the year.

And if anything, worries about consumer spending have only grown in recent months, because of the continued rise in interest rates and oil prices and the ongoing slowdown in the housing market.

All of this has had Alan Loewenstein feeling cautious. "We were very worried going into the second-quarter numbers," says Loewenstein, a portfolio manager who focuses on the technology sector for American Fund Advisors. "April and May were strong for the economy, but in June things started to weaken."

That weakness has been showing up in recent earnings reports from technology companies. The oft-repeated themes of those reports have been slowing sales and disappointing -- or even gloomy -- forecasts of coming quarters' results. They've been echoed not just by the mature companies in the sector but by the upstarts as well.

Given the two companies' performance of late, Dell's warning and Intel's disappointing guidance last week weren't totally unexpected. But tech's troubles also hit eBay ( EBAY), Yahoo! ( YHOO) and Amazon.com ( AMZN) in the Internet sector; smaller chipmakers such as LSI Logic ( LSI) and RF Micro Devices ( RFMD); and business software companies such as Business Objects ( BOBJ) and RightNow Technologies ( RNOW).

Even Apple, one of tech's highest fliers in recent years, offered light guidance and reported the slowest growth ever with its crucial iPod product line.

What's more, the backdating scandal just won't go away.

Like the macro picture, it too just seems to be getting worse. The scandal centers on stock option grants, long the currency of choice of technology companies when paying employees.

Various investigations have indicated that companies handed out options that carried exercise prices equivalent to short-term lows in the companies' stock prices days or weeks after those lows occurred. Federal regulators are investigating whether the companies that allegedly backdated options properly accounted for and disclosed them to investors.

At first, the number of companies involved was just a handful. But regulators are now investigating more than 80 companies in the backdating scandal. With other companies already conducting their own internal investigations or subject to shareholder suits over their grants, many more could come under federal scrutiny. Regulators filed their first criminal charges in the probe last week, against Brocade ( BRCD), and indicated that more will come.

Meanwhile, the impact is showing up in earnings reports. Because of ongoing internal investigations into their options accounting, companies such as KLA Tencor ( KLAC), McAfee ( MFE), Atmel ( ATML) and Altera ( ALTR) had little to report to investors about their recent quarterly results and could give little guidance about their earnings expectations for coming periods.

At first, the backdating issue looked like it might be "only specific to a few companies," says Loewenstein. "Now everybody's looking, and unfortunately, they're finding a lot more."

Restating earnings to correct for the options accounting problems "makes a company a lot clearer going forward," he says. "But it's still a negative, especially in a negative environment."

Given that the Nasdaq has now posted two 40-point rallies in its past five sessions, some stocks seem to be shaking off the tech taint as investors start looking again at individual names, instead of holding their noses at the whole sector. Despite its mixed report, Apple, for instance, has seen its stock jump more than 20% in the last two weeks.

But for the time being, bounces by individual stocks are likely to be more common than is a sustained tech rally, especially if consumer spending slows down.

"We're cautious near term," Lowenstein says.

As it turned out this past spring, such a stance could make a lot of sense.


TechWeek Scorecard
Index Closing Change
Nasdaq Composite 2094 3.7%
Philadelphia Semiconductor 412 7.0%
Goldman Sachs Software 175 17.4%
TSC Internet 196 1.6%

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