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Whats the matter with tech stocks?
Many tech stocks still cost too much, and growth has slowed. But now theres an entirely new reason our biggest techs look more vulnerable.
By Jim Jubak
It's not impossible for the stock market as a whole to go up if technology stocks don't. But it sure is hard for a short-term stock rally to turn into an honest-to-goodness bull market without the sector of Cisco Systems (CSCO, news, msgs), Intel (INTC, news, msgs) and Microsoft (MSFT, news, msgs) leading the way. That's especially true if the financial sector, that other great bull market leader, is struggling under the weight of more-than-expected interest rate increases from the Federal Reserve.
So even if you don't own a single technology share, you'll want to know the odds that technology stocks will get it together and take on the role of bull market leader that the sector so often assumed in the 1990s.
Here are two possible outcomes:
- If tech stocks do lead the market, the pattern -- if not the absolute magnitude of the gains -- will look like 2003, when the technology-heavy Nasdaq Composite ($COMPX) returned 50% and the Standard & Poor's 500 Index ($INX) returned 26.4%.
- If tech stocks continue to show only periods of modest gains separated by steep declines, then 2006 will look like a replay of 2004 or 2005, when the Nasdaq returned 8.6% and 1.4%, respectively, compared with 31.8% and 47% for the Philadelphia Oil Service Sector Index (OSX). (The S&P 500 returned 9% and 3%, respectively).
Unfortunately, the odds of technology stocks continuing to struggle in 2006 are pretty high. If that's true, investors like you and me need to search for the sectors or sector that will outperform the market if we're looking for anything more than modest returns.
Related news and commentary on MSN Money
Analyzing why technology stocks are likely to struggle again in 2006 also suggests a strategy for the years ahead. I'll follow up what is a fairly pessimistic analysis of the near-term prospects for the sector with, in my next column, a way to patiently invest now for the better returns that are due closer to the end of the decade. And I'll give you three stock picks for doing just that.
Maturation, stagnation
So what's the matter with technology stocks?
The conventional analysis fingers two culprits:
- The technology sector has matured, and sales and revenue growth have slowed.
- Even after the huge sell-off in the sector that began in March 2000 and ran through the first part of 2003, technology stocks are still overvalued, especially in light of the slowdown in sales and earnings growth.
Dell (DELL, news, msgs), which reported earnings on Feb. 16, is a good example of both problems.
The company managed to beat Wall Street earnings estimates of 41 cents a share by two cents. Earnings grew by 16% year over year.
But the positive earnings surprise didnt survive even the usual cursory Wall Street analysis. A lower-than-expected tax rate -- the result of more of Dell's sales taking place in lower-tax countries -- was responsible for a penny of the surprise. And two to three percentage points of the company's growth resulted from the 2006 quarter running a week longer than the 2005 period.
And the earnings report turned positively gruesome when Dell started to talk about the rest of 2006. The current quarter, Dell CEO Kevin Rollins said, would show revenue growth of just 6% to 9%. That's big bad news at a company that grew revenue by 18%, 21% and 16%, respectively, in comparable quarters in 2003, 2004 and 2005. Earnings, the company projected, would be 39 cents to 41 cents for the quarter, flat with the January quarter and only 5.4% to 10.8% ahead of earnings for the April 2005 first quarter.
If growth in revenue and earnings is slowing to a single digit pace, then Dell's shares at $30.38 aren't exactly cheap, even if they are down from a high of almost $42 in July 2005. After a decline of almost 28% from that date, the shares are still trading at 23.6 times trailing 12-month earnings per share.
That's certainly not a bargain price if Dell is growing earnings at 12%, as Wall Street now projects for fiscal 2007 -- or maybe less if the downturn projected by the company for the April quarter lasts more than just a quarter.
OK, that's the conventional explanation of why technology stocks can't get a rally going. Earnings growth in these mature businesses is too low and the stock price is still too high -- given that slower growth.
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