Why the Nasdaq Outperformed the Blue Chips

Despite a nasty recession, investors in the technology sector had plenty to celebrate in the first half of 2009. But some question whether tech stocks can continue posting gains for the rest of the year.

In the first half of 2009, technology shares did more than just outperform. Tech stocks were stock market stars, beating every other sector by a wide margin. Now as the market enters the second half of the year, tech investors say they wonder how long their luck can hold out.

Of 10 sectors in the broad Standard & Poor's index of 500 stocks, seven have shown negative returns so far in 2009, according to data provider Capital IQ. Of the three sectors that actually moved higher, consumer discretionary stocks rose 9% and the small materials sector gained 14%. By contrast, information technology stocks jumped 25%.

Because so many tech stocks are in the Nasdaq composite index, it trounced other major indexes. For the first six months of the year, the Dow Jones industrial average was down 3.8%, the S&P 500 was up 1.8%, and the Nasdaq gained 16%.

That's quite a contrast to the last recession, when the bursting of the tech bubble decimated many portfolios. From 2000 to 2002, the Nasdaq lost more than 60% of its value.

Portfolio managers cite several reasons why tech was so attractive in 2009 despite the severe recession.

Techs slashed inventories and output

Technology firms weren't unaffected by the downturn, especially in late 2008, when companies canceled software purchases and hardware orders dried up. "Tech got hammered in the second half of last year," says Richard Parower, portfolio manager of RiverSource Investments.

But tech executives had learned lessons from the severe downturn earlier this decade. "They were pretty aggressive in cutting inventories and production," says Dan Genter, chief executive and chief investment officer at RNC Genter.

The combination of a steep decline in business and ruthless cost-cutting in 2008 set tech firms up for a quicker rebound in 2009, he says.

With so much bad news already factored into their stock prices, tech shares started attracting bargain-hunting value investors. "These stocks were considered too cheap," says David Stepherson, portfolio manager at Hardesty Capital Management.

In the first six months of 2009, investors underwent an abrupt mood swing, with the broader market dropping steeply until March and then bouncing back on rising optimism. But tech stocks rallied throughout the first half of the year, in both of these very different market environments.

When conditions were gloomy, says Uri Landesman of ING Investment Management (ING), investors were attracted by tech companies' strong balance sheets. With lots of cash and little debt, tech firms didn't need to rely on frozen credit markets for financing.

When credit conditions stabilized and investors began to hope for a recovery, tech stocks rose on hopes they would share in a return to prosperity.

M&A stirred interest in tech

Many tech firms will be among the first stocks to benefit from a better economy, Stepherson says. Companies have learned that tech spending pays off, particularly in boosting the productivity of firms hit by layoffs. "You don't have to pay benefits to your laptop and your server," he says. "Where you had 10 people doing a job, now you might need six."

Other factors have helped tech, experts say. Some merger-and-acquisition activity has attracted interest in the sector, Landesman says. Most notably, Oracle (ORCL) reached a $7.4 billion deal in April to buy Sun Microsystems (JAVA).

Another factor, harder to quantify, is politics. Other stock market sectors are weighed down by worries about new regulations from Washington that could raise costs. Congress and the Obama Administration are considering health-care reform legislation, new financial regulations, and a climate-change bill that could affect the energy and utilities sectors.

"The government regulatory magnifying glass isn't on [the tech] sector," Stepherson says.

Parower notes that the tech sector could be hurt or helped by new regulations on other sectors: For example, tough new rules on financial firms could leave Wall Street with less money to buy tech products. But new disclosure rules from the government could also require technological upgrades so firms can comply, he says.

Investors are divided as to whether tech can continue its run in the second half of 2009.

"A lot of people are saying tech is the place to invest now," says Steven Rogé, portfolio manager at R.W. Rogé. "But I think we've seen the majority of the outperformance in the sector."

As the economy improves, Rogé expects other, more economically sensitive stocks—such as commodities producers—to beat out tech stocks.

A key factor for technology stocks will probably be earnings reports. Intel (INTC) reports results on July 14, followed by IBM (IBM) on July 16, Microsoft (MSFT) on July 23, and Cisco Systems (CSCO) on Aug. 5.

Oracle's results on June 23 sent its shares higher after the company's earnings, revenue, and new software bookings all beat analyst predictions.

"Expectations have gotten pretty high," Parower says. "We've been expecting tech to tread water here for a while."

But Landesman argues that tech stocks remain reasonably priced because the sector has a good chance of beating the market's earnings expectations as the economy improves.

Much may depend on whether the U.S. economy improves fast enough to meet investors' heightened expectations for the tech sector.

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