Catch Us If You Can

by | Apr 4, 2003 | POLITICS

It’s back to last December 31, and we’re playing a New Year’s Eve guessing game. The country is heading for recession and war — so what will the stock market do in the first quarter of the new year? If I told you that and Yahoo! would break out to highs not seen in […]

It’s back to last December 31, and we’re playing a New Year’s Eve guessing game. The country is heading for recession and war — so what will the stock market do in the first quarter of the new year?

If I told you that and Yahoo! would break out to highs not seen in more than two years, that information technology would be the best-performing Standard & Poor’s 500 sector and that the NASDAQ 100 would be up 7.8% while the Dow Jones Industrial Average would be down 1.7%, you’d be checking to be sure I wasn’t the designated driver.

But I would have been right.

How could it have happened? What could be the reason why the riskiest and most vulnerable stocks in the market — these burned out bull-market leftovers — have turned in the best performances during these dangerous times? I suppose you could write it off to the fact that the market always does whatever it has to do to make the largest number of people feel stupid. But actually there are a number of good reasons, and they happened to come together all at once here in the first quarter of 2003.

This simplest explanation is that technology is finally undergoing a real earnings recovery. For the rest of the S&P 500, trailing 12-month earnings bottomed in December 2001, after a drop of 8.8% from the peak earlier that year (by now they’re practically all the way back to peak levels). But for the information technology sector, earnings didn’t bottom until last October — and that was after a drop of 60.7%. There’s a long, long way to go until we get anywhere near the peak again.

So tech has been the late bloomer of the earnings recovery — with lots and lots of room for a cyclical earnings bounce-back. Add to that the fact that sadder-but-supposedly-wiser technology analysts had slashed their estimates to ridiculously low levels — and now they have to scurry around upgrading them to catch up.

Right now, tech is at a point where analysts can make a real growth argument without feeling too terribly silly about it. What can you say at this point to justify the belief that a company like, say, Coca-Cola should expect anything like the double-digit earnings growth that investors got used to during the previous heady decade? But it’s not so hard to imagine that kind of growth coming out of the tech sector: The consensus 12-month forward growth-rate estimate for the tech sector is 37.0% — and actual earnings are coming in now at a pace that fully justifies that kind of expectation.

And tech earnings are not just recovering quantitatively — they’re recovering qualitatively, as well. That’s because the companies that went into the tech wreck of 2000-03 aren’t same companies coming out the other end. There are lots that are never going to come out — but they don’t count anymore, because with their miniscule market capitalizations they don’t even register in the major indexes like the NASDAQ. The ones that are coming out are stronger, leaner and meaner. They have survived the worst and now are positioned to be more competitively dominant and enjoy fatter margins than they could ever have done when times were easier.

And let’s not forget President Bush’s proposed tax cuts! I’ve written many times in this column about how the proposed elimination of the double taxation of dividends and retained earnings, and the proposed acceleration of cuts in personal income-tax rates, would be great for America’s economic growth. Well, when the nation’s overall growth rate accelerates, the most growth-sensitive sectors of the economy are always the biggest beneficiary — and that means tech. The performance of the tech sector may be sending us a strong signal that the market is betting that Bush will get a lot of what he’s asking for.

There are several other reasons why tech has performed so well this quarter, and they have everything to do with today’s deeply unsettling climate of extraordinary military, security, political and diplomatic uncertainty.

First, in a time when the entire structure of the world economic order is threatened, younger and nimbler companies may have an advantage. Older, larger commodity-oriented companies — ones thought to be safe and secure, such as, again, Coca-Cola — have enormous manufacturing and marketing investments dependent on the status quo everywhere in the world. When the status quo is fundamentally altered, it’s hard for them to adapt. What would happen to Coke’s earnings if France, Germany, Russia and China — countries that publicly rebuffed the U.S.’s initiative to disarm Iraq — decided that they didn’t want American sugar-water manufactured or sold in their countries anymore?

And second — and this one is the hardest for most investors to grasp — in times of extreme risk, risky stocks are the least risky. And that’s good for tech, because tech is the riskiest sector. But why is this so?

Well, if you’re afraid of some truly great calamity — such as another major terrorist attack in a U.S. city, something that could cause widespread panic and could shut down the markets for weeks or months — you want to have as little money at risk in the market as you possibly can. But while you’re afraid of that, you know it’s a low probability — so part of you has to be worried that if it doesn’t happen, you’ll be vulnerable to missing the next up-move in the market. So what do you do? You buy tech.

Because tech stocks are the most volatile and risky, one dollar invested in tech has the same upside effect in your portfolio as two dollars in, say, the consumer-staples sector. So you put half the money at risk by buying tech — you get all the upside, but only half the downside if the mega-catastrophe you fear actually does happen.

Put all these ideas together, and it seems to me that we’ve more than explained why tech has done so well so far this year. So that leaves the question: How long can it continue? The answer: for a while, but not much longer. Tech stocks aren’t overvalued now in any absolute sense — but they aren’t as wildly cheap as non-tech stocks are right now. In fact on a relative basis — relative to non-tech, that is — tech is now about as overvalued as it’s been at any time in the last two decades except for March 2000.

So maybe we’re setting up for another installment of a lesson that the market just loves to teach us over and over and over again: Anytime a majority of investors think something is “safe,” it’s not. I don’t think the idea that tech is safe has quite made the conventional wisdom yet, but it’s getting there. So be careful.

The above was an “Ahead of the Curve” column published March 28, 2003 on, where Luskin is a Contributing Editor.

Don Luskin is Chief Investment Officer for Trend Macrolytics, an economics research and consulting service providing exclusive market-focused, real-time analysis to the institutional investment community. You can visit the weblog of his forthcoming book ‘The Conspiracy to Keep You Poor and Stupid’ at He is also a contributing writer to

The views expressed above represent those of the author and do not necessarily represent the views of the editors and publishers of Capitalism Magazine. Capitalism Magazine sometimes publishes articles we disagree with because we think the article provides information, or a contrasting point of view, that may be of value to our readers.

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