COMMENTARY--If history is any indicator, the Federal Reserve's fifth interest rate cut this year might be just the tonic for the ailing stock market and tech sector.
The Federal Reserve, citing weak capital spending, cut interest rates by a half point Tuesday. Although Fed rate cuts haven't jumpstarted the tech sector yet, economists and tech executives are hopeful the fifth cut will do the trick.
The Standard & Poor's 500 index and the Nasdaq gained an average of 20 percent and 28 percent, respectively, 12 months after the Federal Reserve cut interest rates five times, according to Salomon Smith Barney. Those returns are based on market performance for 1971, 1975, 1982, 1986 and 1991.
Averaging in the stock market's performance from the depressions of 1930 and 1937--when the Fed also cut interest rates five times--the S&P 500 gains just 6.46 percent. The Nasdaq didn't exist in the 1930s.
Although investors had a muted response to the Fed's decision to cut interest rates Tuesday, Salomon equity strategist Tobias Levkovich said the S&P 500 and Dow should hit his targets of 1,400 and 11,400, respectively. Those indexes currently are perched at 1,249.44 and 10,872.90.
"We should begin to see earnings benefits in the second half as the cumulative effect of the Fed easings begins to take hold," said Levkovich. "Given projected earnings recovery in 2002, we envision more upside by year-end."
So what's in it for the tech sector? Levkovich said the S&P Electronics (semiconductors) group jumped 63.8 percent following five Fed interest rate cuts dating back to 1982. Other S&P indexes haven't been around long enough to provide meaningful data.
Chip-related stocks seem to benefit the most from the interest rate cuts. Intel (Nasdaq: INTC), National Semiconductor (NYSE: NSM) and chip equipment maker Applied Materials (Nasdaq: AMAT) all posted gains topping 100 percent following five Fed cuts. Advanced Micro Devices (NYSE: AMD) gained more than 90 percent. Those returns were skewed a bit by the bull market, which started in 1982, but are still impressive, said Levkovich. Retailing and financial sectors also did well.
Fed Chairman Alan Greenspan seems intent on cutting interest rates until capital equipment spending rebounds. Even though many companies, especially high-tech ones, have cut inventory, capital spending remains weak. That's why the Fed on Tuesday said it will remain vigilant over the economy. Merrill Lynch is projecting another rate cut of a quarter point at the Federal Reserve's June 27 meeting.
"The Fed's main concern is that capital spending has continued to decline and the erosion in current and prospective profitability and an uncertain business outlook will act to keep it weak," said Michael Carey, chief economist for Credit Lyonnais Securities.
A mixed bag of earnings prove Carey's point.
Applied Materials on Tuesday reported second-quarter earnings of $269 million, or 32 cents per share, excluding special charges. Sales for the quarter dropped 30 percent from the preceding quarter to $1.91 billion. Applied Materials cut its outlook for its fiscal third quarter, but said business probably won't get any worse.
Although the chip equipment giant didn't give any details about when its business would improve, it did note that Greenspan's rate cuts will eventually help.
"An accommodating Fed policy should put the economy on the right track," said David Wang, executive vice president at Applied Materials, on a conference call with analysts. Wang added that the Fed rate cuts will give companies some confidence to forge ahead with information technology spending. He expects a PC sales recovery to start in the second half.
Calling a bottom was a common theme Tuesday as tech companies reported earnings and said the worst is almost over. "We believe that the second quarter was the low water mark for our business," said Brocade Communications CEO Greg Reyes. "We are now seeing signs that IT budgets may be thawing as companies reprioritize projects based on return on investment (ROI)."
But a thawing doesn't mean companies can predict when business will improve. Numerous tech companies such as Cisco Systems (Nasdaq: CSCO) have refrained from projecting earnings and sales beyond the current quarter. Analysts expect information-technology spending to remain stagnant for at least a few more months. That means more interest rate cuts, albeit less dramatic ones, may be on deck.
"We expect a rebound in growth by the fourth quarter and strong growth during 2002. But so far that remains a forecast, and the Fed has to deal with the reality of how the economy looks right now, which is weak and fragile," said Bruce Steinberg, an economist at Merrill Lynch. "That calls for more easing, though at a more gradual pace than has been the case so far this year."
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