The last 18 months have been extremely volatile for technology investors, encompassing both a powerful bull market and a painful bear market that continues to weigh on the technology sector.
Volatility in recent months has been on an unprecedented scale. Why did the market rise so rapidly and fall again in such a short space of time?
In essence, there are two reasons behind the rise and fall. First, the US economy enjoyed a massive boom in spending because of the cuts in interest rates that took place in late 1998 and early 1999. This boom led to the Federal Reserve increasing interest rates in summer 1999.
Markets tend to anticipate economic movements by 12 months, so the fall that began last spring was effectively signalling a sharp slowdown in economic growth in spring 2001. Note, however, that no economist predicted this sharp slowdown so once again the market has proved a better indicator of the economic cycle.
The second reason for the fall in the technology sector was simply the enormous interest in the sector from institutions and private investors. Unfortunately, as shorter-term investors such as hedge funds and day traders jumped on to this bandwagon, valuations became overextended. But we continue to believe the fundamental technology story remains intact.
In a disinflationary environment where companies enjoy zero pricing power, spending on technology remains largely non-discretionary and should be considered as a cost of remaining in business.
Over the last few months, the fall in the market has caused valuations to be corrected to the extent that the sector is trading at around 15 per cent below the long-term ratio of price to earnings relative to growth. In other words, the sector is cheap but has not yet recovered because of uncertainty about the level of economic growth this year.
We remain slightly overweight in telecom equipment as we are confident that telecom operators will continue to deploy next-generation networks. While second-half earnings' growth slowed from the exceptional levels of the first half of 2000, we continue to anticipate healthy, more normalised levels of growth for 2001.
We believe valuations reflect this backdrop and, in some instances, look very attractive.
Inventory build-up has plagued semi-conductor companies recently. Earnings disappointments from bellwethers such as Intel, Xilinx and Altera have dragged sector valuations to their lowest level since 1998.
While it might take two quarters to clear the inventory out of the channel, we do not believe this heralds the end of the cycle. Although we remain underweight in semi-conductors, we have recently been adding to the group ahead of a bottoming in sentiment and short-term fundamentals.
Profit warnings in PC-related stocks have been commonplace as a result of anaemic growth in PC end demand. Dell, Compaq, Gateway and Apple have missed recent expectations and warned that channel inventory has increased and orders remain weak.
We continue to be underweight in this market due to its slowing growth prospects and lack of near-term rationale for a major corporate upgrade.
Looking towards hardware, we continue to favour storage companies such as EMC and Network Appliance and leaders in the enterprise hardware arena such as Sun Microsystems.
We remain overweight in the software sector due to our belief that spending on core software applications and platforms, which add value, improve productivity and have short payback periods, will not be affected significantly by a slowdown in capital expenditure in 2001. Favoured themes within the software arena are supply chain, customer relationship management and storage management.
IT spending remains an essential expenditure in a tougher economic environment as companies strive to improve efficiency and reduce costs. The technology sector is as cheap as it has been in the last two years and valuations of many leading technology firms are attractive.
For the long-term investor, there is no other sector of the global economy that offers a better opportunity for sustained growth. Concerns over the macro environment will continue to weigh heavily on technology stocks and will not diminish volatility until the economic outlook is clearer.
At the beginning of January, the Federal Reserve cut interest rates by 0.5 per cent to 6 per cent. The Fed cited further weakening of sales and production in the context of lower consumer confidence and said inflation pressures were contained, while technology-related gains in productivity remained in place.
We would expect to see further easing of interest rates by the Fed in the next few months, which should enable the soft landing for the US economy to occur.