Nasdaq: The Worst May Not Be Over


By Margaret Popper Something was eerie about the Nasdaq's January rally -- from around 2250 to around 2850 in just three weeks. Sure, a certain optimism always takes hold of the market after New Year's Day, but this time it was in the face of too many negatives. Now that the February doldrums are upon us, the Nasdaq index is hovering around 2490. At least it hasn't dropped all the way back to 2251, the 52-week low hit in December.

But many market analysts still believe that the tech-laden index has some correcting to do and that it could easily drop below its previous one-year low, to around 2100 (see BW Online Video Views, "Another Nasdaq Nosedive?"). Then it's gut-check time. If the Nasdaq falls to that level and holds steady, start buying, say market mavens. But if it whizzes through 2100 and keeps dropping, analysts think it may not stop until 1600 or lower.

How quickly might this happen? "Investors want instant gratification," says Tracy Eichler, investment strategist at PaineWebber. "But this market isn't going to give it to you." That's because earnings season is nearly over, and absent any more good news from the Federal Reserve or economic data, the market is trading on first-quarter prospects. Although guidance about corporate earnings keeps getting lowered, analysts still haven't adjusted their forecasts to fully account for the effects of the economic slowdown, which some believe will continue into the third quarter, while others say it'll be a first-half phenomenon.

AFFORDABLE PROP. Fact is, the tech sector still suffers from some fundamental problems. "The tech bubble created an artificially low cost of capital and no barriers to entry that resulted in a fragmented industry with overcapacity," says Richard Bernstein, chief quantitative strategist at Merrill Lynch. He thinks even Fed Chairman Alan Greenspan "may not be able to save the tech sector." The Nasdaq's 52% drop since its March high and the consequent stepped-up merger activity are only the first steps in a shakeout that will see hundreds of companies shut down before this sector's supply adjusts to demand, say analysts.

As for monetary policy, many fear that Greenspan & Co.'s efforts to revive overall economic growth could give false hope to techies, unintentionally reinflating the bubble. "If you're a long-term tech bull, you want the sector to consolidate," says Bernstein. But by lowering rates, the Fed could potentially make debt affordable to prop up some tech companies that can't raise any more cash in the equity market. Without a debt infusion, these companies would otherwise be figuring out how to make a graceful exit.

Since changing to an easing bias at the end of last year, the Fed has dropped interest rates a full percentage point. No one is expecting easing to continue at that pace, but the market is counting on more of the same. Of course, there's no guarantee that newly available capital would go to the tech sector, but the Fed doesn't control that. "When the Fed eases, it would be a shame if all the capital flowed into a sector whose fundamentals are deteriorating," says Steven Wieting, U.S. economist at Salomon Smith Barney.

EARNINGS REALITIES. The more likely scenario is that so-called Old Economy stocks will benefit. That would be good news for the Dow Jones industrial average and the Standard & Poor's 500, neither of which has taken the beating the Nasdaq has the past few weeks. Recently, these far-less-tech-dependent indexes have actually inched upward as the Nasdaq has meandered south. At its current level of around 10,940, the Dow is 4% off its 52-week high of 11,425 last April. The S&P 500 now trades around 1327 and is 14% off its March high of 1552 -- but that's nowhere near the pain of the Nasdaq's 52% plunge over the same period.

Still, the S&P 500 and the Dow aren't immune to earnings shocks. The Dow simply had most of its earnings troubles the first half of 2000, when the tech sector was doing great. That's when consumer cyclicals like Coca-Cola, Kodak, and Procter & Gamble began to show signs of weakening.

The S&P 500, on the other hand, could have its own mini-correction lurking when investors come to grips with earnings realities. The companies in the S&P 500 reported earnings that were 2% below expectations for the fourth quarter, and yet the index rallied in January even as disappointing earnings reports piled up. "The market was primed to see disappointment in December," says Milton Ezrati, senior economist and strategist for Jersey City (N.J.) fund manager Lord Abbett & Co.

"ABYSMAL." The problem is that while analysts adjusted their expectations downward quarter-by-quarter for 2000, very few revisited their quarterly projections for 2001. As a result, if you take the average of Wall Street analysts' projections for the first half of 2001, S&P 500 earnings are expected to grow 11% in the first half of 2001. Compare that to the consensus of economists at many of the same Wall Street firms, who predict an annual earnings growth rate of 7.5% for the year, with the faster pace coming in the second half.

The math doesn't add up. And even the economists' conservative estimate is squishy since many of them now worry that the earnings problems could continue into the third quarter of 2001, assuming it takes at least nine months for Fed policy to trickle through the economy. "You won't see the fruits of the Fed easing in the second quarter," says Ezrati. "Earnings will be abysmal." Nor is it clear that the economy will be able to make a complete turnaround in the third quarter alone, says Ezrati.

Either way, because of fundamental overcapacity in the tech sector, its earnings turnaround may not come in tandem with overall economic growth. "People think the [info tech] bubble has been surgically removed, but we'll be paying the price for years to come," says Stephen Roach, chief economist for Morgan Stanley Dean Witter. What does that mean for shareholders? Those who still have their cart hitched to the Nasdaq may want to look around for a new star in 2001. Popper covers the markets for BW Online in our daily Street Wise column


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