Nasdaq's Climb: The Air Is Getting Thinner

Just a few stocks are behind the index' steep rise

The Nasdaq stock market may not turn out to be the "market for the next 100 years," as its slogan goes. But based on the recent performance of some of its stocks, it's almost certain to be the market for 1999.

Since the beginning of the year, the Nasdaq Composite Index has returned an eye-popping 47.5%. That's compared to 20.2% for the Dow Jones industrial average and 16.1% for the Standard & Poor's 500-stock index. Still, the major gains in the Nasdaq have occurred only in recent weeks, with the index posting a 21.7% of its gain since Oct. 19, largely due to communications-related technology stocks. "Basically, strong third-quarter earnings, along with decreasing concerns about Y2K problems, are fueling the tech stocks," says Steven M. Milunovich, technology analyst at Merrill Lynch & Co.

How long will the tech rally last? Or, perhaps more pertinent, how high will Nasdaq go? The optimists say the current rally is just the latest manifestation of the New Economy, and that the sky is the limit for tech stocks because of their unstoppable growth. "Whenever stocks like Yahoo! dip, you see no selling and mostly buying. That's the market's way of telling you something very good is happening in these stocks," says Laszlo Birinyi, a Greenwich (Conn.) money manager who studies the effect of money flows on the market. Birinyi predicts the Nasdaq will rise to 3500, or 6%, by the end of this year and will reach 4000 by 2000's end.

CONCENTRATED LEADERSHIP. But others say despite sky-high tech stock prices, investors need to keep their feet planted firmly on the ground. "This is one of those rallies where the strength isn't nearly as broad-based as people are trying to conclude," says Christine A. Callies, chief market strategist at Credit Suisse First Boston. "The leadership is concentrated in a few large-cap blue chips and in the recent crop of untested IPOs." Some of those high-flying, high-tech initial public offerings: Expedia, Finisar, and Wireless Facilities.

In fact, according to Salomon Smith Barney, almost 40% of the gain in the Nasdaq Composite Index since Oct. 1 can be attributed to only five stocks on a market-cap weighted basis: Cisco Systems, MCI WorldCom, Qualcomm, Oracle, and Sun Microsystems. "In this environment, investors lose tolerance for owning anything less than the best performers," says Callies. "They'll sell their lesser performing stocks to buy the big gainers, and that's cannibalization." Thus, as the rally gets narrower and narrower, the overall market gets worse and worse, she says.

Indeed, as the Nasdaq Composite Index and various technology sector indexes have roared ahead--the S&P High-Tech Index is up 18% since mid-October alone--other areas of the market continue to languish or lose ground. The Russell 2000, a small-cap stock index, is up only 9.7% year-to-date and the S&P Barra Value Index is up 12.7% for the year.

"When gains are concentrated within a tight sector and so few stocks, you have to worry that investors are being myopic. Their sentiment can change at the drop of a hat on a negative earnings report, inflation fears, or whatever," says Richard Bernstein, chief quantitative analyst at Merrill Lynch & Co.

In fact, some big tech stocks have already stumbled since the rally began. IBM, for instance, sank 15% on Oct. 21 when it announced it wouldn't meet analysts' fourth-quarter estimates due to weaker sales and Y2K problems. Hewlett-Packard Co. and Xerox Corp. have been sandbagged by investors because of similar woes.

Next year, the tech sector is expected to have slower earnings growth. First Call, the earnings research firm, expects technology stocks to post profit gains of 27% in 2000, compared to 34% for 1999. "Tech isn't going to be the highest growth area next year, but we're coming into more normalized year-over-year comparisons," says Charles Hill, First Call's director of research.

Nasdaq's Climb: The Air Is Getting Thinner

As tech issues continue to rise, investors will be more apt to take profits, slowing the ascent. "The concern is they're overbought," says Merrill's Milunovich.

Though the Nasdaq rally may fade, it doesn't mean a halt to the bull market. There's good news in seasonality. From Thanksgiving to the end of January, the market tends to outperform other times of the year because of money inflows from yearend bonuses and tax-loss selling. And, despite the strong economy, the earliest the Federal Reserve is expected to raise interest rates is February.

Even if the Nasdaq naysayers are right and the rally fizzles, one thing is almost certain: 1999 will go down as the year of the Nasdaq.

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