The long road back
Despite heady gains, it will be a long time before investors see Nasdaq 5000 again
Timing is everything when it comes to investing. No one knows that better than Mitchell Rubin. Manager of the Baron iOpportunity Fund, Rubin had the misfortune of launching his technology portfolio a little more than a week before the Nasdaq composite index peaked above 5000 in March 2000.
"We had like five good trading days," says Rubin. Then the party came to a crashing end in a correction for the ages that would eventually push the index down as low as 1108 in October 2002.
Even profitable companies in Rubin's portfolio were brought back down to earth. EB ay, for example, lost nearly half of its market value in 2000. "There was absolutely no place to hide," says Rubin.
Recovery. For Rubin, patience would eventually pay off. By hanging on to some Internet leaders, his portfolio has recovered most of its losses from the tech sector's crash. Unfortunately, most tech investors can't say the same.
Wall Street will soon be celebrating the five-year anniversary of the bursting of the Internet bubble, when the "new economy" ran headlong into an old-fashioned grizzly bear. But while broader market measures like the Standard & Poor's 500 index of blue chip stocks and the Dow Jones industrial average have made up virtually all of their losses, the Nasdaq remains nearly 60 percent and nearly 3,000 points below its peak of 5048. "What sort of amazes me is that 2003 was a great year for technology," says Vincent Gallagher, managing director and portfolio manager for the Needham Funds. "I would have thought that having had that, it would have been a little closer to its old highs."
So much for high hopes. One explanation for why the Nasdaq is having so much trouble crawling its way back to 5000 may be that it never deserved to be there in the first place. "This was really the bubble of a generation, if not a century," says David Dreman, chairman and chief investment officer of Dreman Value Management. "It really ranks up there with tulipmania," he adds, referring to the 17th-century crash in the Dutch tulip bulb market.
The confluence of dot-com mania alongside the technology buildup stemming from fears over Y2K led to unprecedented capacity in the telecom and technology sectors. Because the Nasdaq is so much more concentrated in tech and telecom companies than are the Dow or S&P, it may take years for the index to return to its previous highs. Even if the index were to consistently return 20 percent a year--a big "if" --it would still take another five years for it to hit 5000 again. That's on top of the five years that have already passed. "For the index to get back to 5000 anytime soon, we would need to have some other fascination reminiscent of the Internet boom," says Louis Harvey, president of the financial-consulting firm Dalbar.
Realistically, says Chris Orndorff, head of equities for the asset management firm Payden & Rygel, "it could be another six or seven years before we're talking about Nasdaq 5000 again." While that's a long time by the standards of today's volatile markets, it's by no means unprecedented. It has been 15 years since the Nikkei 225 peaked at nearly 40,000, and the index of Japanese blue chip stocks is nowhere near its prior levels.
A big stumbling block for the Nasdaq is that it is capitalization weighted, meaning big stocks have more sway on the index's movements. Yet the biggest blue chip tech stocks in the Nasdaq have not recovered nearly as fast as its smaller Internet names. Some haven't recovered at all.
Microsoft, the biggest and most influential name in the Nasdaq, has lost 4. 3 percent a year over the past three years. Intel, another megatech stock, has slumped 13.7 percent a year. By comparison, eBay is up nearly 50 percent a year for the past three years while Amazon.com is up 53.6 percent annually. And Google has been soaring since its initial public stock offering. The disparity in the performance of megacap and smaller tech may continue. While earnings for blue chip tech companies in the S&P 500 index are expected to rise 14 percent in the first quarter of 2005 and 11 percent in the second quarter, earnings among smaller tech companies in the S&P 600 index of small stocks are expected to grow 20 percent and 28 percent, respectively.
Though tech stocks have been beaten down for several years now, there is still some evidence that the mania that propped them up in the late 1990s isn't quite over. Tech sector earnings are expected to be only average in the coming years, yet investors continue to reward tech stocks with rich valuations.
Overvalued? Consider this: Tech stocks in the S&P 500 command a price-earnings ratio of 26.2, based on 2004 operating earnings, according to S&P. That's the richest P/E ratio for any sector in the economy. By comparison, the S&P's overall P/E ratio stands at just 17.9. "Old habits die hard," says Payden & Rygel's Orndorff.
While many former day-traders, having learned their lesson, may now be happy plowing $10,000 into their homes rather than Internet stocks, "there is still a segment of retail investors who are willing to chase performance," says Baron iOpportunity's Rubin. "But the average lawyer or doctor or dentist putting all their net worth into stocks like Theglobe.com--that era is over."
Moreover, it's overly simplistic to say that tech has been an abject failure for investors. "If you look at a chart of the Nasdaq, it looks like tech is done for--that tech has fallen and can't get up," says Kevin Landis, chief investment officer for the tech-oriented Firsthand Funds. "But if you look at other measures, you'll see the success of tech."
Landis points out companies like eBay and Amazon.com that have lived up to their promise of revolutionizing retail through online selling. And while the cellphone business has been riddled with problems in the past few years, cellphone use and sales continue to flourish.
Like previous manias, the big lesson of the bursting of the Nasdaq bubble has been this: Investing ideas come and go, but very few companies can successfully capitalize on even the best ideas for the long run. Just as the development of railroads and radios and cars once proved revolutionary, only a handful of companies survived to lead each of those industries.
The same thing is occurring with the Internet. The challenge, then, isn't waiting for another Nasdaq 5000 but finding tech stocks that are likely to set new highs.
This story appears in the January 17, 2005 print edition of U.S. News & World Report.