"New economy" stocks take a beating

That's what many investors are asking in the wake of today's harrowing ride on the Nasdaq composite index, which dropped more than 500 points in midday trading.

The tech-heavy index recovered most of its losses, closing at 4,148.90, down just 74.78 points. But that didn't placate nervous investors and economists, who predict that the days of easy Nasdaq windfalls are over.

Although technology stocks in general offer greater returns than investments in the "old economy"--made up mainly of established companies in industries such as manufacturing--tech stocks' growth is slowing. At times, the Dow Jones industrial average, filled with old-economy blue chips, has outpaced the Nasdaq.

The Dow has climbed about 13 percent since March 7, while the tech-heavy Nasdaq has plummeted by more than 16 percent during the same time.

Walter Murphy, senior international market analyst with Merrill Lynch, said the new economy stocks may have been riding a bubble that has popped.

"I think it's more of a case where the bubble is caught in a downdraft," said Murphy, who expects weakness in the Nasdaq to last for months, rather than weeks or days.

Bottom line: Investors accustomed to 20 percent annual returns are in for a disappointing year, said Richard Rogalski, professor of investments at the Amos Tuck School of Business at Dartmouth College in Hanover, N.H.

"We may come in this year at 10 percent to 12 percent growth, and a lot of people will be upset at that lousy performance," Rogalski said. "But a lot of established investors who've been doing this for a long time would be happy with that...The mentality now is to increase your wealth substantially in a short time, and that's not sustainable."

The slowdown in tech shares comes as investors are growing wary of relatively young companies with unprecedented price-to-earnings ratios, such as e-commerce giants eBay and Amazon.com. Nasdaq stocks trade for an average of 188 times profit, while companies in the Dow Jones industrial average trade for 27 times recent earnings.

"My sense is that there's an extraordinary amount of hype that has rationalized disconnecting stock valuation with the underlying earnings or profit model," said Ronald Masulis, professor of finance at Owen Graduate School of Management at Vanderbuilt University in Nashville. "Given the stock prices we've seen, it's very hard to match up these prices with all these companies' earnings. Any drop wouldn't be too surprising."

Many analysts blamed the weeklong retreat from the technology sector on uncertainty about the future of Microsoft. The software giant has long been a bellwether tech stock and a key component of the overall U.S. stock market.

Yesterday, U.S. District Judge Thomas Penfield Jackson found that Microsoft stifled innovation and could be held liable under state anti-competition laws. Microsoft stock fell $2.31 today to $88.56, extending yesterday's plunge of $15.38.

But Microsoft's legal plight and ensuing stock tumble may be too narrow an explanation for the broader Nasdaq retreat and the Dow's lackluster performance for the past week.

Wells Fargo economist Don Hilber said today's market drain involves investor pessimism for the fabled get-rich-quick tech stocks.

"When 1999 closed out, the sentiment was that the stocks were overvalued and would suffer a fall at some point--and apparently it didn't happen until now," Hilber said. "But nothing in terms of these companies' valuations or profit expectations has changed since the beginning of the year. (The drop) must be a combination of sentiment and momentum."

Other experts blame the volatility on an eventual shakeout in the technology sector. Investors are trying to decide which companies will die, survive or thrive as the industry matures.

"If you go back and look at other times in other industries in U.S. history, it's always been an enormous explosion of innovation with an enormous number of entries in the field. Then many fell by the wayside," said Russell Roberts, an economist at the Center for the Study of American Business at Washington University in St. Louis.

"Not every Internet bank or mortgage company or portal or bookseller is going to make it," he said. "What isn't clear is: How many will be left, and how profitable will they be? Everyone's guessing."

The selling pressure may have been amplified as shares were sold to cover margin calls. Investors are permitted to borrow up to 50 percent of the money needed to buy stocks.

As stocks fall, brokerages can force the borrower to put up more cash. If an investor cannot immediately raise the cash to cover the "margin call," the shares can be sold. Typically, more investors buy technology stocks on margin than blue chip stocks.

Another factor contributing to Nasdaq volatility is the increase in day traders--individual investors who cruise the markets looking for quick profits and are quick to bail out of stocks that take even a small dive. Day traders accounted for 11 percent of Nasdaq volume during the first quarter of 1999, according to Hambrecht & Quist.

But long-term investors shouldn't behave the same way as day or margin traders. Benton Gup, finance professor and banking chair at the University of Alabama in Tuscaloosa, said people who don't need to liquidate their stock portfolio for a year or more should largely ignore daily fluctuations. Tech stocks promise the greatest return, he said, despite their nerve-racking variations.

"If you're investing for the long haul, don't worry about the day-to-day," Gup said. "It's like the weather: If it's really nasty and cloudy in San Francisco, you don't move out of town because you know that the weather will improve eventually. Don't sweat it."

Dan Gillespie, senior portfolio manager of Rydex Funds, which has $8.5 billion in assets, hasn't lost confidence in the tech sector, despite today's rough ride.

"I'm certainly not going to sell off my technology holdings," he said. "The American economy is based on technology, and that's not going away."

News.com's Dawn Kawamoto contributed to this report.