Stocks: What Happened to the Tech Rally?

(This story has been changed to correct the spelling of Chris Armbruster.)

If you talked to portfolio managers at any time in 2009, chances were good that they would extol the virtues of technology stocks. The information technology sector of the Standard & Poor's index of 500 stocks rocketed 59% higher last year, beating every other sector and doubling the broad index's 23.5% advance in 2009.

How quickly fashions change on Wall Street. A month into 2010, tech is down 8.2%, more than any sector but telecommunications, itself off 8.9% this year. The S&P 500 has dropped 2.3%.

The tech sector has lost steam despite good news on both the U.S. economy—such as a 5.7% rise in gross domestic product last quarter—and from technology companies themselves.

On Jan. 29, for example, tech heavyweight Microsoft (MSFT) reported earnings of 74¢ a share, 15¢ more than analyst predictions tallied by Bloomberg. Yet the results merely deepened Microsoft's stock decline this year. After rising 57% in 2009, Microsoft shares in the new year have fallen 7%.

The tech selloff has been broad. The Nasdaq 100-stock index includes large-cap tech stocks such as Microsoft, along with Apple (AAPL), which is down 8.8% this year; (AMZN), down 13.9%; Qualcomm (QCOM), off 15.3%; and Google (GOOG), which has fallen 14.6% this year. Only 18 Nasdaq 100 members are in positive territory in 2010.

time to rebalance portfolios

Conversations with stock-fund managers suggest several reasons why tech stocks are having a tough year.

First come seasonal factors. In a new year, investors tend to rebalance their portfolios. After tech's great run in 2009, it's likely that many managers need to sell tech stocks to return their portfolios to their preferred sector allocation, notes Sean Kraus, chief investment officer at CitizensTrust.

Experienced traders have come to expect good results from tech companies late in the year, so they're often ready to take profits early in the new year. "The smart money gets out, despite the good news," says Kraus.

Another drag on tech stocks has been worries about growth, both in the U.S. and around the world—a factor that also has hurt the broader stock market.

Kevin Mahn, chief investment officer of SmartGrowth Funds, believes the economic recovery could disappoint many optimistic tech investors. In the U.S., the 10% unemployment rate will constrain consumer spending, which in turn will hurt business investment in new technology, Mahn says. "If people aren't spending and businesses aren't spending, how is technology going to lead the way?"

Worries that the Chinese economy is overheating have also hurt technology stocks because most tech companies are global businesses. To buy tech stocks, investors "need confidence that global growth is not going to slow," Kraus says. Moves by China's government to rein in GDP growth, which exceeded 10% in the most recent quarter, to keep inflation at bay have raised concerns among investors worldwide.

Tech: too popular, too fast?

A recent rally in the U.S.dollar is also posing a problem. A stronger dollar makes U.S. tech companies' overseas profits appear smaller on income statements. The U.S. dollar index—measuring the greenback against a basket of foreign currencies—is up 6.6% since its 2009 low on Nov. 25.

The main reason for tech's underperformance may just be that the sector grew too popular, too fast.

"People often get too excited about the prospects for tech," says J. Stephen Lauck, chief executive of Ashfield Capital Partners, who nonetheless likes the sector's long-term prospects. Tech outfits often feature greater innovation and faster growth than companies in other sectors and their stocks are also more volatile, prone to quick advances and rapid declines, he says. Investors know this, so they're quick to take profits at signs of trouble.

Much of last year's excitement about tech is still reflected in the sector's valuations. According to Bloomberg data, the Nasdaq 100 has a price-to-earnings ratio of 21.57. That's quite a rebound from the index's P-E of 12.9 on Nov. 21, 2008. The S&P 500's current P-E ratio is 18.5.

Faster growth expectations arguably justify tech's pricier valuation. According to Bloomberg, analysts give the Nasdaq 100 earnings a long-term growth rate of 14.8%, compared to 9.7% for the S&P 500. Tech P-E ratios also match recent history: The Nasdaq 100's average P-E over the last five years is 27—although the economy was much better in most of those years.

tech earnings expectations now lag

"You can buy many outstanding, market-leading tech companies for very little, if any, premium," says Lauck.

Analysts have become more optimistic about tech in 2010, reflecting upbeat earnings results and better data on the economy. Here too, the sector has lagged the rest of the stock market. According to Bloomberg data, expectations for S&P 500 earnings growth this fiscal year have risen 25% in just the last four weeks while for the Nasdaq 100 index, expectations climbed 15.4%.

Despite recent setbacks, many investors remain enthusiastic about technology stocks—particularly their long-term prospects.

The sector is producing "a tremendous amount of innovation," says Larry Rosenthal, president of Financial Planning Services in Washington, who sees this as a good buying opportunity for stocks in the category. "Tech is going to be a leader as the economy emerges [from recession] over the next three or four years," he says.

Tech's proponents frequently cite the prospect of increased demand from both consumers and businesses. Consumers may be short of cash, but spending on consumer technology held up surprisingly well last year, notes Peter Misek, global technology strategist at Canaccord Adams.

consumer demand fuels tech sales

Apple, a company very popular with consumers, saw sales rise 32% last quarter.

Peter Klein, Microsoft's chief financial officer, said in a Bloomberg interview on Jan. 29 that consumer demand, not business demand, has driven the company's recent strong results. "We are not seeing the enterprise recovery yet," he said. "The timing of that recovery is uncertain."

Many economists believe businesses are beginning to open their wallets. In a statement on Jan. 27, the Federal Reserve noted that "business spending on equipment and software appears to be picking up."

Misek says there is pent-up demand for corporate tech spending. "As company earnings continue to accelerate, we think capital spending on technology is going to rise," he says.

Tech stocks could face difficulty repeating 2009's rapid advance in 2010. But many tech enthusiasts say they will be patient. "It might be a couple years out before you see a lot of momentum, but it's something we're willing to wait for," says Chris Armbruster, vice-president of research at Al Frank Asset Management.

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