NEW YORK (CNN/Money) -
The Federal Reserve will probably raise interest rates soon. And that's causing tech investors to flee for the exits.
It indicated as much Tuesday. Although it left rates unchanged for the time being, the Fed, as expected, removed the word "patient" from its closely watched statement about the economy and its current monetary policy stance.
The Nasdaq has fallen nearly 7 percent since early April after a surprisingly strong March employment report stoked fears that interest rate hikes are on the way. Chip stocks and telecom equipment companies have particularly taken it on the chin: The Philadelphia Semiconductor Index has dropped 15 percent in the past month while the Amex Network Index has plunged 17 percent.
And this has occurred despite some impressive first quarter earnings reports from a lot of tech bellwethers in April. Why are investors ignoring the good news?
The conventional wisdom is that higher rates are bad for stocks in general because it raises borrowing costs for companies, thereby putting a dent in earnings. What's more, investors are concerned that rate hikes could cause businesses to slow down their purchases of things like computers, servers and software.
Hoping history repeats itself
But will a series of rate hikes really put a damper on tech stocks? A look back at some other periods of Fed rate increases indicates that the market is worrying needlessly.
The Fed raised rates five times in 1988 but the Nasdaq went up 15.4 percent that year and wound up increasing another 19 percent in 1989. That last fact is impressive since economists say that it tends to take several months for interest rate increases to have a tangible effect on the economy.
Remember 1994 and early 1995? The Fed tightened seven times during a 12-month span, driving up the federal funds rate a total of 300 basis points (3 full percentage points). The Nasdaq did take a slight hit in 1994 but wound up surging 40 percent in 1995.
"I don't think there's a lot of evidence to suggest that a tech fallout synchronizes with rate hikes," said Pip Coburn, global tech strategist with UBS.
Plus, most techs don't rely on the debt markets to raise money anyway. Large cap techs like Microsoft (MSFT: Research, Estimates), Cisco Systems (CSCO: Research, Estimates), Dell (DELL: Research, Estimates) and Intel (INTC: Research, Estimates) have balance sheets so clean that you can eat off of them.
And even if techs did need to raise funds, few are expecting the Fed to be as aggressive as it was in 1994 and 1995, particularly since there hasn't been enough of an improvement in the job market and wage growth to merit a full-fledged inflation scare. So the market may be fretting about higher rates, but rates are likely to remain relatively low for the foreseeable future.
The federal funds rate currently stands at 1 percent, its lowest level in nearly four decades. By way of comparison, the federal funds rate was at 6.75 percent when the Fed began tightening in 1988. And in 1994, the federal funds rate was 3 percent before the Fed began to jack up rates.
"Even if the Fed raises rates, and I think they will raise 50 to 75 basis points between now and January, you are still talking about dirt cheap rates to borrow," said Todd Campbell, president of E.B. Capital Markets, an independent research firm catering to institutional clients.
In fact, David Joy, market strategist with American Express Financial Advisors, said that as long as the Fed doesn't make drastic moves, then there is no real need to worry about an economic slowdown until the federal funds rate is somewhere between 3.5 percent and 4.5 percent.
"Rate hikes don't have to mean the death knell for tech spending. Fundamentals are still strong," said Joy.
Valuations, not rate hikes, is tech's biggest problem
It's also important to remember why the Fed is considering raising rates in the first place: It's because the economy is showing signs of strength. That is a good thing for tech stocks.
"Rising rates clearly amplifies that the economy is improving and that there should be more spending on technology. We don't take that as a negative," said John Rutledge, manager of the Evergreen Technology fund.
| * data as of 5/3/04 | | Source: Thomson/Baseline |
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All that said, tech investors might have another reason to worry. Tech stocks did enjoy a massive rally in 2003 after three down years. The Nasdaq gained 50 percent last year. So it's only natural for techs to cool somewhat this year.
"Tech has been the biggest factor behind the latest bull run, so the fact that stocks are down seems fairly reasonable," said Tobias Levkovich, chief U.S. equity strategist with Smith Barney. "I hesitate to sit back and say this a great buying opportunity."
I agree with him to a certain extent. The 83 tech stocks in the S&P 500 are currently trading at an average of 36 times 2004 earnings estimates, twice the multiple for the broader market.
Valuations, and not the prospect of interest rate hikes, should be the biggest cause for concern. Simply put, much of this year's good earnings news is already factored into many tech stocks.
But some large cap stocks have fallen due to rate hike fears and now look downright attractive. Hewlett-Packard, Intel, Applied Materials and Oracle, for example, have all seen their stocks fall in the past month and are now trading at less than 25 times 2004 earnings estimates. These four have low debt levels and solid growth prospects as well.
So just because Alan Greenspan is getting ready to put on his trusty rate hiking boots, that doesn't mean that it's time for investors to walk out on the highest quality tech stocks just yet.
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