While risks persist in the technology market, the Nasdaq Corporate Index could recover to at least the 2,500 level by the end of the year and further throughout 2003
With the Nasdaq Composite Index hovering around the 2,000 level, the technology sector appears to be breaking through its 12-month downtrend. While it would be foolhardy to predict the bottom has definitely been reached, there is gathering evidence that the sector passed through its cyclical trough during the fourth quarter of 2001 and that 2002 should be a brighter year for the sector as the global recovery takes hold. The January/February period will be critical in this assessment process as companies begin to offer their projections for 2002 earnings.
From a market viewpoint, we believe that the lows reached in the market directly after the terrorist attacks on the US will not be revisited. The subsequent recovery in equity markets has been fuelled by signs of economic improvement and we expect to hear more positive news as we progress through the first half of 2002. It is perhaps not surprising that this view is not yet wholeheartedly shared by the market.
A tail of investor pessimism and caution normally follows extended bear markets, given the usual trend of seemingly relentless quarterly profit downgrades.
Investment managers and analysts tend to acquire a siege mentality, keeping their heads down, and investment risks generally low, until good news emerges.
Ironically, these periods are often one of the sweetest spots in the investment cycle. Historically, equity markets and other higher risk investments outperform when interest rates are falling, profit momentum is weak and, most importantly, before the economic recession has ended.
Since the early 1970s, all equity bull market recoveries have commenced between two and six months before economic recession has finally ended.
If our global outlook for 2002 is correct and the US emerges from recession in the first half of 2002 (dragging the global economy with it), then the current equity market recovery is happening right on cue. In fact, based on market movements since late 2001, the magnitude of recovery is directly in line with historical observation as well. The 2000/01 bear market, while accentuated by the economic recession, was initially triggered by the squeeze on global liquidity in early 2000 as the Fed sought to mop up the liquidity injected ahead of the Y2K transition (after having seen that very liquidity create the investment bubble in the first place). This story has now turned a full cycle, with an extremely accommodative policy injecting central bank liquidity directly into the global economy and financial markets.
The creation of free liquidity is impressive, outpacing any prior period seen since the early 1970s. This is a measure of the seriousness with which central banks are pursuing stimulatory policies.
However, a further important source of liquidity, with the potential to drive the equity market recovery, is the shear weight of global private sector savings that are available to invest. As discussed, investors became highly defensive in 2001, leading to an explosion in cash and bond investments. This is likely to be a temporary phenomenon however.
The bond market has now turned and short-term interest rates are at such unattractively low levels that this capital will almost inevitably eventually circulate towards riskier investments should markets remain in their recovery phase.
In the corporate world, companies should start dusting off IT projects this year, which were shelved during the downturn. IT remains a strategic necessity, enabling companies to compete in a world where competition is becoming increasingly intense. Software companies are likely to benefit more than most from an upturn in corporate capital spending.
Rolling out e-commerce platforms and applications remain at the top of the priority list for corporations, despite the delays in deployment this year. Security spending is also very high on the list, given that cyber attacks continue to increase in number and severity.
One argument used against technology is that companies over invested in the 1990s and will not make the same mistake again.
This argument presumably infers that investment in IT will decline as a percentage of capital expenditure from the current level of roughly 50 cents out of every US dollar.
The problem with this argument is that it assumes there is a better way to invest capital or that capital investment should simply wane. Yet the whole crux of technology spending is that it substitutes capital for labour, which results in higher productivity, enables faster design of products, more efficient production and distribution of goods and more effective customer relationship management.
All of these add value to a business, and once the hardware, software and related IT processes are built into a business model, you cannot simply rip them out and go back to basics; you have to continually upgrade.
The argument goes on that companies cannot afford to invest any more because of corporate debt-to-GDP ratios. Sure, things are tough right now, but in a world of tough competition that is not getting easier, companies cannot afford not to invest.
The key to survival and ultimately growth is to improve productivity, lower operating costs and change your business model to adjust to permanent lower pricing. There is no substitute for investing in IT if higher productivity is required. The correlation between technology investment and productivity in the US is incredibly strong.
Of course, there are risks out there. One possible constraint to growth through the coming cycle is likely to be the magnitude of global productive overcapacity.
This reflects an extended strong period of demand and thus investment throughout the 1990s. Given the lower level of demand during any downturn and the early part of the subsequent recovery, capacity utilisation is likely to be low. The good news of course is that these conditions are disinflationary, thus allowing a very low level of interest rates.
Another risk is that during the coming cycle, persistent and intense competitive pressures are likely to prevail. This could result in constrained pricing power, leading to a relatively poor profit recovery.
However companies in a prolonged disinflationary environment will be under intense pressure to improve productivity. Given the link between technology investment and productivity, technology companies should be able to weather such a period relatively well.
Of course, a prerequisite of sustainable economic recovery is that consumer spending remains stable at worst. Post-11 September, the response from the US consumer ' a consumer freshly armed with cheaper credit ' has been to engage in a bout of patriotic purchasing in an effort to keep the country going.
While consumer confidence indicators remain volatile, actual consumer spending running into the Christmas period was relatively strong, particularly online spending for companies like AOL and Amazon. If these spending trends continue, then the inventory reductions that have started in earnest should continue throughout the technology sector.
Inventories appear to be under control: there has been heavy restructuring within the sector and companies are generally in much better shape now than they have been at any point in the last twelve months.
Returning to stock markets, while it is impossible to predict short-term market movements, we are convinced that world stock markets will do what they always try to do and look through to the next economic cycle.
The first quarter of the year is normally a seasonally weak one for the technology sector in terms of company earnings. With prospects of economic recovery, share prices should continue to recover.
Having said that, we do not expect individual stock volatility to drop away as the global slowdown is bound to leave a few stings in its tail. While there are still risks in the shape of extraneous events and in terms of consumer confidence, 2002 looks at least like providing the turning point for the global economy and the technology sector.
Overall, we would be disappointed if the Nasdaq Composite Index did not recover to at least the 2,500 level by the end of this year with further recovery in 2003.
There is growing evidence that the tech sector passed through its cyclical trough during Q4 2001.
Since the early 1970s, all equity bull market recoveries have commenced between two and six months before recession has finally ended.
Software companies should benefit more than most from upturn in corporate capital spending.
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