Commentary: Why the Tech Rally Is No Freak Performance
That sound from Wall Street this week was the sharp snap of minds changing about technology stocks. The NASDAQ Composite Index average jumped 5% on July 7 and 8, to cross 1,700 for the first time since May, 2002. It's now up 31% for the year. The biggest catalyst was a survey of corporate technology buyers that Goldman, Sachs & Co. released on July 7, saying that tech spending will rise about 5% next year by Goldman's reckoning, the first gain since 2000. That may not sound like much, but consider the source: Goldman has been bearish on tech for two-plus years.
Is Wall Street getting carried away? Maybe, but not as much as it may seem. Tech companies have been beating their earnings estimates for the first time in two years. Renewed business confidence is raising hopes that CEOs may start spending again. And because info-tech companies have cut costs so drastically over the past three years, even a modest uptick in capital spending should fall straight to the bottom line.
Profit expectations are rising as fast as stock prices. The price-earnings ratio for the 80 tech stocks in the Standard & Poor's 500-stock index is 28, compared to 18 for the S&P 500. That's the same as it was in early January, despite a 21% gain in blue-chip tech stocks this year. That's possible because investors expect profits from early 2004 to be 20% higher than in early 2003.
The tech story has been slowly improving all year. Info-tech companies beat analysts' estimates in the first quarter, with earnings up 17% from early 2002. Second-quarter profits should grow 20%, says Thomson Financial First Call, rising to 29% for the whole year. Optimists also point to a 14% jump in June sales at bellwether chipmaker Taiwan Semiconductor Manufacturing (TSM ) Co., which may signal more PC demand.
More important, sentiment is improving in the corner office. Randell Moore, editor of newsletter Blue Chip Economic Indicators in Kansas City, Mo., predicts a 7.5% hike in capital spending next year, up from 1.1% in 2003. And on July 8, the National Association of Business Economists said spending on computers and telecom gear will be "significantly stronger than for overall capital spending."
Tech companies are lean enough to make an earnings recovery on the slimmest uptick in demand. Tech's 17% first-quarter earnings gain was achieved with only a 2% rise in revenue. Look at Hewlett-Packard (HPQ ) Co. After $3.5 billion in cost cuts, analysts think HP will triple last year's October quarter earnings on only a 6% revenue gain. At some point, though, demand needs to pick up to keep the momentum going. "You really have to have that recovery in '04," says Bill Keithler, director of sector investments at Invesco Funds Group in Denver. "We think we will."
This isn't a cue to buy everything at any price. Dot-com leaders eBay (EBAY ) Inc. and Amazon.com (AMZN ) Inc. are so pricey, even bulls counsel a cooling-off period. The doubling and tripling of share prices at weaker companies is riskier yet. Sun Microsystems (SUNW ) Inc., even at $5 a share, trades at 50 times fiscal 2004's projected earnings.
Yet the market is doing what it's supposed to do -- predict a recovery just before it arrives. As is always the case, some people won't believe it's real until companies move from talking about spending to actually whipping out the wallet. But that's a natural consequence of the disappointments of the last three years. Tech's long winter is finally drawing to a close.
By Timothy J. Mullaney
With Ben Elgin and Jim Kerstetter in San Mateo, Calif.