The Nasdaq Reloaded
By Michael Wallace
In Hollywood's latest blockbuster sequel, The Matrix Reloaded, humans are pitted against a villainous cyber-empire. In the version of reality that we call the present, the battle against technology has been waged by bitter investors who expected more from the New Economy than it could initially deliver.
The fallout has been severe. In the aftermath of a brutal three-year bear market that saw valuations of many tech outfits implode (a spectacle that needed no fancy special effects), investors haven't been the only ones to suffer. Wall Street and Corporate America took a few licks as well -- just look at the $1.4 billion Wall Street research settlement, separation of investment banking from research analysis, and accounting reform.
The Matrix sequel may leave viewers with a cliff-hanger, but the real-world "ending" to the tech bubble's bursting may turn out to have a more positive outcome. Five months ago we argued that equity prices weren't reflecting the tech sector's first glimmers of a comeback (see BW Online, 12/26/02, "A Tailwind for Tech at Last?").
And now it appears -- as in the Wachowski Bros.' middle installment of the Matrix trilogy -- that the machines may have the edge again. With the tech sector leading the way, overall business spending may recover just as consumers pause to regain their breath.
So far this year, equity prices have caught up to the nascent tech recovery. The tech-laden Nasdaq composite index rebounded nearly 15% before shedding about 3% of those gains on May 19. The Philadelphia semiconductor index, or SOX, has defied gravity and vaulted 22% higher since January before profit-taking knocked 5% from its May highs.
In early March, the Nasdaq benefited from breaching a key technical level: The 100- and 200-day moving averages on the index crossed 1,360, foreshadowing a near 200-point move from March lows of 1,253 to recent highs of 1,550. Meanwhile, the SOX has rallied over 100 points since February, to the 360 level.
What's driving the upswing? The end of Gulf War II, a relatively encouraging first-quarter earnings season, lower borrowing costs (via tighter corporate credit spreads and 45-year low benchmark bond yields), a weaker dollar, and generous Federal Reserve policy all have rewarded investors. While investment brochures may caution that "past performance is no guarantee of future results," the tech sector this go-round has been stubbornly resilient.
Other evidence supports the likely improvement in profits and business spending on technology. In its March report on economic developments in the Western U.S., the San Francisco Federal Reserve Bank found that capacity utilization by computer-equipment makers and semiconductor manufacturers, though still below average, was on the rise, and "the increases appear to be holding."
A return to more normal levels of capacity use is one prerequisite to hiring, and a sign that demand may be picking up -- a cause helped by the weaker dollar as well. While employment trends in the sector remain mixed, the "outlook is improving," the SF Fed notes, as earnings recover.
The March report on global chip sales from the Semiconductor Industry Assn. also lent some much-needed cheer. The release showed a monthly sequential sales increase of 2.6%, to $12.1 billion, from February, and a 13% sequential sales increase in the first quarter, despite all the then-current geopolitical distractions. Geographically, sales in Asia grew by 17.2%, in Europe they gained 11.3%, while falling 8% in the Americas, reflecting some "migration" of production to the Pacific Rim.
The SIA expects double-digit percentage sales gains in 2003 and, like the SF Fed, noted that capacity utilization in the sector ramped up beyond 90% in March. This suggests that tech companies may have to expand capital spending after years of paring inventories to meet future demand. Such a trend would be a sign of gathering traction in business spending. After the beating that the tech sector has taken the last three years, a positive earnings streak and more consistency in growth would be quite timely, especially if consumer spending should slump markedly.
Another encouraging sign for tech investors: The broader equity indexes have done a respectable job of protecting their gains despite an onslaught of mostly disappointing economic data and the Fed now publicly acknowledging "minor" deflation risks.
The May 6 statement from the Fed's policymaking arm, the Federal Open Market Committee, that referenced the "D" word is being read as a signal that central bankers will at least sustain, or even step up, their accommodative policy, rather than prematurely hike rates to ward off the beginnings of inflation (see BW Online, 5/9/03, "Why the Fed Is Ready to Cut Again"). Fed Chairman Alan Greenspan's appearance before the Joint Economic Committee of Congress on May 21 will be closely scrutinized for any further indications of possible easing.
One intriguing aspect of the Fed pulling for growth and scanning the horizon for deflation is that stock and bond gains for a time appear compatible. Multidecade lows on yields of both short-term and long-term fixed-income securities and narrowing spreads between the yields on benchmark and corporate bonds should only further galvanize the tech and business sectors.
Sure, the May 19 Nasdaq sell-off shows that some doubts remain about the viability of the tech recovery, but the trend remains intact. Over the short term, this likely will help draw out sidelined investor dollars, broadening and deepening the overall recovery. And this time around, if the machines lead the way, even the Matrix believers shouldn't mind.
Wallace is a senior investment strategist for MMS International