High Tech's Woes Spread

Slowing profits at key companies mean stocks may not rebound soon

Ah, October. The month of crisp air, burnished vistas, and bearish stock markets. This year is no different. Since Sept. 1, the Nasdaq Composite Index has spiraled downward, culminating in a 25% drop, with 11% coming just this month. And through Oct. 11, the index is down 37% from its peak on Mar. 10. Nor is Nasdaq alone. Although the Dow is faring a bit better, it is off 7% since Sept. 1, and the Standard & Poor's 500-stock index has lost 10% since then.

Most of the carnage is from large, richly valued technology stocks that have been hit hard due to earnings concerns. But now financial stocks have joined them on the downward slope. Market watchers wonder which sectors are next--and worse, if the bottom will fall out of the entire market. "Everybody's afraid, and trying to get out of the way of trouble," says Charles Pradilla, chief market strategist for SG Cowen & Co.

According to Investors Intelligence, a newsletter that tracks sentiment, investors are not nearly as bullish about the market as they have been for months. The worries have been intensifying for weeks over concerns about a slowing economy, a weak euro, and the potential for corporate profits to slide well into the first half of 2001. As one company after another has announced negative earnings warnings, the pile-on effect has sent market morale plummeting. Investors are punishing not just individual stocks, but entire sectors.

Still, there is some good news amidst the damage: Other sectors of the market, such as pharmaceuticals and utilities, are performing better. This rotation activity could ward off a bear market. "There's a clear move to more defensive names," says Jeffrey M. Warantz, a strategist with Salomon Smith Barney. And as investors rotate into other areas, flows into equity mutual funds stayed remarkably strong. Even as the Nasdaq dropped in September, according to TrimTabs.com Investment Research, investors put an estimated $19.7 billion into equity funds, nearly double the $10.8 billion they put in during Sept. 1999. That followed a strong August, when investors put in $23.4 billion. "To me, it constitutes proof that the rally in the Nasdaq can resume any time," says Carl Wittnebert, TrimTabs' director of research.

He may be more bullish than most, but in any scenario, a quick turnaround in some major tech sectors looks unlikely. That's because profit growth is slowing at key companies. Intel, Dell, Microsoft, and Lucent are suffering an array of problems--among them a weak euro, a slowdown in optical networking sales, and decreasing personal-computer sales. While that may not mean an industrywide slowdown, it could mean continued trouble for major tech sectors, including PCs, telecommunications, mainframe software, and big swaths of the dot-com world.

Moreover, valuations of most tech stocks have plummeted since early September. Many Internet and traditional tech stocks face another looming problem: exceptionally high numbers of outstanding shares and stock options. Both devices have been used as jet fuel to finance aggressive acquisition strategies and attract top employees. But the process can work in reverse when stock prices fall and employees with stock options scramble to sell. Besides, many stock options are now underwater, and if they stay there long, companies will be forced to shell out precious cash to retain top employees.

What's more, the huge amount of stock issued by many tech companies in recent years is now coming back to haunt them. Net stock Internet incubator CMGI Inc., for example, had less than $100 million in revenues in 1998 when it embarked on a $13 billion acquisition binge, paid for mostly in stock. With its share price down 90% from its peak, CMGI's growth-through-acquisition strategy is on hold. And its share base, which jumped from 20 million to 300 million shares, will make it tough to show earnings-per-share growth. In its last fiscal year, CMGI lost $2.2 billion on revenues of just $898 million.

How long tech's trauma will last is unclear. The biggest worries focus on the prospects for Internet stocks. Only a handful of the hundreds of dot-com stocks have gained ground this year, and many are trading below their IPO price. "You'll see a number of companies go all the way to zero and disappear, mostly in the Net sector," says Matthew T. Cowan, general partner with Bowman Capital Management in San Mateo, Calif. "I believe things will get worse before they get better."

ROTATION. Financials, especially brokerages, may also be on the rocks for a while. That's because their profits in recent years have been closely tied to technology--nearly 60% of equity and 35% of high-yield underwritings year-to-date have been in tech or related areas. Also, the heavy trading volume that has been due largely to tech stock mania may start to dry up. Rumors of junk-bond losses at Morgan Stanley Dean Witter are another factor. Although the firm says the rumors are exaggerated, the stock has dropped more than 15% since Oct. 5. "Financials basically ran up because people felt the Fed was on hold, or that they would ease rates, but we thought that was premature, and suddenly there are all these other concerns," says Michael E. Kenneally, chief investment officer at Banc of America Capital Management Inc.

Banks are out of favor, too. "Though it looks like they have adequate reserves to cover loan losses, if the economy slows, those reserves won't be nearly as adequate," says Hugh Johnson, chief strategist at First Albany Corp.

But tech remains the big story, and despite the sector's fizzle, some bulls remain convinced of the sector's overall growth prospects. "Once we get past all these negative announcements, we're going to switch into a mode where companies should deliver strong earnings and begin a rally," says Paul Meeks, manager of several technology funds at Merrill Lynch & Co. And erstwhile bull Abby Joseph Cohen said recently: "Worries about the macro environment have been overdone. The backdrop for technology investments is favorable." Her reasoning: Technology is still growing as a percentage of gross domestic product, and the decelerations of economic growth will elongate the economic and profit expansion. In fact, Cohen still stands by her forecast that the S&P 500 will reach 1575 by yearend. That would mean a 16% gain from current levels.

Even so, for the many investors who are tech-heavy and tech-weary, it may be time to take advantage of the rotation in the market. The gap between earnings in tech vs. other industries is narrower than it has been in years, according to Chuck Hill, First Call Corp.'s director of research. Basic materials profits are expected to be up 26% year-over-year, transportation up 24%, and health-care profits, 16%. "You've got to be looking over your shoulder" at other industries, Hill says.

Since the Nasdaq swooned in September, investors have been moving their money into industries with brightening prospects for strong profit growth, says Sam Stovall, a sector specialist at Standard & Poor's. The biggest winners have been utility and energy stocks such as Duke Energy and Exxon Mobil, pharmaceutical stocks such as Pfizer, and traditionally defensive names in consumer staples including Coca-Cola, Procter & Gamble, and CVS. And within tech, there are some standouts. Specialty semiconductor companies, communications and infrastructure stocks, and networking storage companies should continue to do well, say experts. But for the broader market, one can only hope that sectors other than tech will continue to improve. If not, watch out.

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