Interest Rate Fears Test Techs’ Vulnerability

To most Wall Street traders, rising interest rates rival recession as a killjoy. When rates kick up, it’s as if someone called the police because the party was getting out of hand.

Their impact is less clear-cut for technology stocks. Many tech investors question whether rising rates--pumped up by a strong economy that provokes inflation fears--should deal a recession-like blow to stocks whose attraction is energetic growth. Doesn’t a dynamic economy mean more buying of computers, software, e-commerce services and the like? And since tech companies are so adept at cutting costs, can’t a little inflation expand profit margins?

Market psychology has been seesawing between the search for growth and skittishness about the high prices tech stocks demand. Look at the performance of the Nasdaq composite index Thursday. It retreated more than 60 points early in the session but ended with a 13-point gain when bargain hunters decided that jet fuel was going for the price of kerosene. Then Friday’s rally was cut short when earnings fears about Cisco Systems hit the market.

But inevitably, rising rates dull the allure of all stocks. When bond yields climb, investors will pay less for the same earnings and growth prospects chiefly because interest-bearing securities are the benchmark alternative to stocks.

Many seasoned observers believe tech shares are especially at risk in that environment. Their trademark high-rise price-to-earnings ratios are a way of asking investors to pay for visions of potent earnings growth years into the future. If interest rates siphon cash out of stocks--and threaten to cool the feverish economy--those high multiples can give way quickly.

When prices of most goods and services are stable, customers get accustomed to persistent price cuts in PCs, chips and other gear. “If we had an inflationary situation,” said Charles Pradilla, chief strategist at S.G. Cowen, “tech firms would get back some pricing leverage but the stocks would be overwhelmed by pressure on their P/Es.”

The overall market had been complacent about tech stocks’ P/Es since the depths of the Asian fiscal crisis more than a year ago. By and large, 1999 earnings have been strong, and the Internet’s momentum has inspired enthusiasm about the digital world.

But anxiety has crept in. The Federal Reserve has raised short-term rates twice since midyear and appears poised to continue. Bond yields leaped amid a 1.1% surge in September wholesale prices, announced Oct. 15.

Last week, the yield on the 30-year Treasury bond closed at 6.34%, hovering around its 1999 peak and about 1.5 percentage points higher than early October 1998.

Yet while the diversified Standard & Poor’s 500 index of major stocks is off 8.4% from its record as of Friday, proxies for the tech industry have fared better. The Morgan Stanley High-Tech index has given back 6.6% and the Nasdaq composite only 3.7%.

Their edge over the S&P; isn’t wide, but recall what happened in 1994, the last time the Fed engineered a series of rate hikes. The central bank boosted rates six times that year and once in 1995. The yield on the long-term bond peaked at an alarming 8.16% in the fall of 1994.

In the process, most stocks turned cold. At year’s end, the S&P; had recovered to post a slight loss. The Morgan Stanley tech index, however, surged in lock-step with interest rates in the fall. For the year, it returned a spectacular 34.7%.

Is it different this time? In 1994, techs were seen as one of the few groups that could prosper amid rising rates. Personal computer shipments jumped 30%, carrying the entire food chain with it. Today the PC industry’s revenue growth has stalled, but new markets such as communications and Web-based technologies have kept the tech picture bright.

Despite inflation worries, few market seers expect the Fed to repeat its campaign of 1994 or bond yields to reach similar heights.

“The inflation trend has changed,” said Bill Meehan, chief market analyst at Cantor Fitzgerald. “It’s going up. But I don’t think the Fed will raise rates seven times. The market would crash well before that, and then the Fed would start easing again.”

Yet even moderate upturns in rates are likely to be felt beyond a P/E crunch, says Fred Hickey, editor of the High-Tech Strategist newsletter and a longtime bear. Business conditions will deteriorate, he predicts.

“Capital spending has flourished in the past few years, and half of all that is computer-related,” Hickey says. “Capital spending is known to be interest-rate sensitive because much of it is financed by debt. When you’ve had overexpansion and you see higher rates, you’d expect to see spending slow, and in fact that is what the Fed is trying to accomplish.”

An inflationary environment also can’t help tech companies grappling with shortages of skilled engineers and marketers, Meehan observes. Salaries would climb even higher. But it works both ways: High labor costs drive companies across the economy to replace people with machines.

“That’s why IBM always did well in periods of high inflation,” says Andy Kessler of Velocity Capital.

Amid this tangle of monetary and business trends, bullish portfolio managers such as Kessler and Kevin Landis advise focusing on opportunity.

“I am just trying to own companies that will be doing great things in the coming year,” says Firsthand Funds’ Landis, whose Technology Value fund tops Morningstar’s five-year rankings. “If my companies have the right micro-picture, the ebbs and flows will take care of themselves. I am not making any defensive moves right now--I’m buying.”

Landis and Kessler are adding to their stakes in companies that provide the nuts and bolts of e-commerce. Wherever interest rates meander, their philosophy is that growth conquers all.

“Would you rather put your money in a hard asset like gold or park it with smart entrepreneurs who are building the infrastructure for the next wave of how the world economy operates?” Kessler asks. “If I was investing for the long term, I would do the latter.”

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Lessons of 1994

While the Nasdaq composite index struggled in 1994 as the Federal Reserve pushed interest rates sharply higher, technology stocks--after sliding early in the year--rocketed in the second half. Monthly closes through 1994:

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Source: Bloomberg News

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Edward Silver can be reached at [email protected].