Technology is highly economically sensitive—it's more likely to outperform during periods of economic growth. And the best way to measure economic growth is a country's gross domestic product (GDP).

What Is GDP GDP has four primary components:

US GDP measurements are released quarterly by the US Department of Commerce's Bureau of Economic Analysis (BEA, www.bea.gov). In aggregate, GDP represents the final value of all goods and services produced in the US.

Figure 3.1 shows relative performance of Technology versus US stocks and GDP growth. (In other words, if US stocks returned 10 percent in a given year, and Technology stocks returned 30 percent, that's 20 percent relative outperformance.) Historically, Technology tracks closely with the direction of GDP growth—meaning Tech is likelier to outperform when GDP grows.

The lion's share of Technology demand has typically come from developed regions. However, emerging markets are a growing percentage of aggregate Technology spending, so it's important to follow the GDP outlook for these regions, too.

Industry Factors While Technology is economically sensitive, the relationship isn't black and white—you must analyze economic impact on Technology's discrete industries. Industries can perform differently based on which stage of the business cycle they're leveraged to. Determining whether it's early or late in the expansion can help refine forecasts and improve accuracy. For example, the Semiconductor Equipment sub-industry is one of Technology's most economically sensitive areas. It tends to perform best after the aggregate book-to-bill ratio (see nearby box) has bottomed. Figure 3.2 shows the ratio can trough multiple times during expansionary periods. However, the deepest troughs have historically occurred in contraction just before the start of a new expansion (as shown in Figure 3.2).

Figure 3.1. S&P 500 Technology Relative Performance vs. US GDP Growth Source: Global Financial Data, Thomson Reuters.

Figure 3.3 shows a typical economic cycle—contraction through expansion. Because chip manufacturers scale back production and reduce equipment expenditures during contractions, a prolonged period of underinvestment spurs new equipment orders once demand rebounds and expansion begins. Hence, a larger weight in Semiconductor Equipment stocks before the cycle begins can increase the probability of outperformance. (This same concept can be applied to other areas of Technology, which will be discussed further in Chapter 9.)

Figure 3.2. North America Semiconductor Equipment Manufacturers Book-to-Bill Ratio Source: Bloomberg Finance, L.P.

Figure 3.3. Hypothetical Business Cycle

Fixed investment can have different meanings, but in Technology, it refers to IT spending by the enterprise market—computers, network equipment, servers, etc. Hardware sales are more economically sensitive and typically rebound earlier during expansion, so tracking fixed investment is critically important.

The US publishes fixed-investment data in quarterly GDP measurements released by the BEA. The report breaks investments down further into computers and peripheral equipment and software. While both are worth tracking, fixed investment in computers and peripheral equipment has historically been a better indication of when Technology will more likely outperform.

Figure 3.4 shows Technology outperformance tracking final sales of Computers & Peripherals equipment closely. However, it's also worth noting periods of underperformance. These tend to occur just before sales growth slows, because the market anticipates the downturn. Simply: Periods of strong fixed investment can help Technology outperform, while weak fixed investment can be a drag.

To help forecast the direction of fixed investment, it's critical to look at the sector's largest end markets—financial services, manufacturing, and communications, for example—which account for 21 percent, 18 percent, and 10 percent of global IT spending in 2008, respectively.^[41]

The Financials sector leads the pack for obvious reasons—these firms must store, process, and access massive amounts of sensitive data. Personal client information, account tracking, and transaction processing are all done electronically. As these firms grow they must invest in storage devices, PCs, servers, software, routers, and network equipment.

Manufacturing is more diverse than Financials since it crosses many sectors—Industrials, Energy, Materials, Consumer Discretionary, etc. Over time, technology has made manufacturing increasingly complex, fine-tuned, and efficient. In general, increasing manufacturing levels and capital expenditures translate into stronger IT spending within this vertical.

Figure 3.4. S&P 500 Technology Relative Performance vs. US Fixed Investment in Computers & Peripherals Equipment Source: Global Financial Data, Thomson Reuters.

The communications industry is another big spender—fixed-line and wireless networks both require significant amounts of infrastructure. Equipment is needed to power networks, monitor performance, and manage and maintain traffic flow. To stay competitive, players must invest heavily in technology, so capital expenditure patterns of larger communications firms figure into larger fixed-investment trends.

But again, fixed investment tends to slightly lag Technology outperformance. This means one should consider overweighting Technology if future spending in these markets is expected to increase. Keeping tabs on guidance from top industry players can help in this effort.

Consumers don't technically make fixed investments, but they are significant purchasers of technology. Instead of spending on giant servers and expensive consulting services, they spend on PCs, cell phones, and consumer electronics. And the two largest drivers of aggregate consumer spending are income and employment levels. Very similar to fixed investment, overweighting Technology before consumer spending rises can increase the probability of generating more favorable results.

Rising Incomes As an economy grows, aggregate income levels tend to follow. In most world regions this leads to stronger consumer spending. Some of this spending will be on actual Technology products—a new computer, cell phone, or MP3 player. But even spending on non-Technology items—automobiles, clothes, new homes, even financial products—indirectly impacts Technology because it leads to higher spending by manufacturers (a large end market for Technology products).

Low Unemployment Low unemployment generally goes along with strong economic growth. As profitability increases, many businesses seek further growth opportunities, which can increase labor demand. Coupled with rising incomes, this creates a perfect environment for robust consumer spending.

Component Shipments

Components are the bits and pieces, odds and ends of hardware used to build working final products like computers, mobile handsets, and televisions. These include semiconductors, hard disk drives, and LCD panels. They're one of the first building blocks in the technology manufacturing chain, so shipments tend to rebound early in the business cycle.

This makes the Philippines an area of focus since electronics are its primary export, totaling 58 percent of the nation's total exports in 2008.^[42] And those electronics exports are mostly basic level components—semiconductors and hard disk drives. Figure 3.5 shows that, historically, the Technology sector generally outperformed during periods of strong or increasing Philippines electronics exports. Put another way, it's generally considered better to be overweight Technology when shipment growth is strong. There are many forces working on stocks all at once, meaning no single indicator should be used for buy and sell decisions. However, if this indicator were being used in combination with many others, it typically gives a positive (overweight) signal when shipment growth increases to 13 percent or more and a negative (underweight) signal when growth falls below 13 percent. As shown, this rule is not particularly helpful prior to the mid-1990s when there was minimal outsourcing to the Philippines.

Figure 3.5. S&P 500 Technology Relative Performance vs. Philippines Electronics Exports Source: Global Financial Data, Thomson Reuters.

And, while this relationship seems intuitive, it's always worth testing. Figure 3.6 shows year-over-year change in global discrete device shipment and relative performance of the Technology sector. As in the Philippines example, Technology outperformance has typically tracked strong or increasing discrete device shipments.

Inflation, specifically, sharp disinflation (a slowing in the rate of inflation), can be a positive Technology driver. Broadly speaking, Technology firms are volume monetizers, not price monetizers. Consider Technology's unique nature: Most of the sector's products are in a never-ending state of deflation—prices fall over time. For example, for certain equivalent-capacity notebook hard disk drives, prices fell by approximately 20 percent in the first half of 2007 alone.^[43] While this is an extreme example, most Technology products follow a similar directional trend. This means Technology firms must constantly improve productivity and establish economies of scale to maintain profit margins—a task that becomes significantly easier when inflation slows.

Figure 3.6. S&P 500 Technology Relative Performance vs. Global Discrete Device Shipments Source: Global Financial Data, Thomson Reuters.

The Core PPI Finished Goods Index represents a good gauge of input prices for Technology firms. Figure 3.7 shows Technology's relative performance as well as growth in Core PPI Finished Goods. Technology outperformance has typically followed sharp declines in PPI growth. A potential explanation for this relationship is the substitution effect. As other goods fall in price, consumers and businesses can purchase more discretionary Technology products. Based on this relationship, it is considered better to overweight Technology when year-over-year PPI growth falls below 2.3 percent.

Figure 3.7. S&P 500 Technology Relative Performance vs. US Core PPI Finished Goods Source: Global Financial Data, Thomson Reuters.

Supply and demand is a basic, broadly applied economic concept—increased supply leads to lower prices, constrained supply to higher (holding demand constant). But few apply this fundamental concept to stock prices. Initial public offerings (IPOs), secondary offerings, stock option issuance, and mergers financed with newly issued shares all increase supply—bearish for stocks. Conversely, share repurchases and cash-based acquisitions decrease aggregate stock supply and can be bullish—whether on a sector level or for broader markets.

This was clearly illustrated during the Technology IPO boom during the 1990s. By 1999, over half of the 685 US stock IPOs came from the Technology sector—a number that increased another 40 percent in 2000.^[44] The total value of these IPOs in 1999 and 2000 was approximately $29 billion and $38 billion, respectively. Moreover, many Tech firms infamously issued massive amounts of stock options to employees as compensation. Share count skyrocketed, making each one less valuable. Coupled with a lack of viable business plans, equity supply became unsustainable and the "bubble" eventually burst. The cycle didn't end, however. On the way down, many Tech firms were bought or went bust. This reduced oversupply and helped set up the sector for future stock price appreciation.

The Technology sector is characterized by constant innovation and upgrade cycles where research and development is paramount. Most often, these innovative ideas or technologies come from narrow, focused areas. However, every now and again a new technology or product has the ability to drive broad demand and thus performance across the aggregate sector. History provides some examples.

Innovation Outside of the personal computer, one of the greatest recent innovations is the Internet, which fundamentally shifted the way society and businesses function. While it existed for many years, wide-scale adoption didn't occur until the 1990s. During this time, demand for Internet access skyrocketed, which in turn helped drive performance across the aggregate Technology sector.

Why did the Internet have such broad impact on the sector? Before consumers and businesses can access the Internet, infrastructure is needed. This bolsters demand for wiring, routers, switches, and powerful computers to manage network traffic. Then, users must purchase Internet-capable computers. Not only does this boost hardware and software demand, but computers are the single largest end market for semiconductors. Chip producers begin expanding to meet demand, which drives sales of semiconductor equipment. This chain of events is a large reason why the period is often called the "tech boom."

Upgrade Cycles Upgrade cycles are another form of innovation, though not in the sense described previously. Rather, these are driven by newer, "updated" derivatives of existing hardware, software, or components. Over time, various cycles exerted sizeable influence on Technology performance.

The Pentium microprocessor in the 1990s is a good example. Performance enhancements in each new generation were significant, leading consumers and businesses to continually upgrade their PCs. Those upgrades drove further demand for hardware, software, and components.

Another example: Microsoft Windows has generated multiple upgrade cycles. Since its creation, the operating system has been broadly used by both consumers and businesses. And almost every subsequent release has almost instantaneously become the industry standard. Most require more robust hardware to run properly. As a result, Windows releases historically have typically spurred demand for new PCs—which of course then bolstered demand for semiconductors and components and helped drive aggregate Technology performance. The effects of both Pentium- and Windows-driven upgrade cycles on computer sales are shown in Figure 3.8. As illustrated, not every upgrade cycle drove computer sales higher—the Pentium 4 had little effect since it didn't deliver much incremental benefit to consumers. Windows XP, however, reaccelerated growth, mainly because of its stability and better compatibility with corporate network environments relative to predecessors.

Figure 3.8. US Computer Sales Growth & Upgrade Cycles Source: Thomson Reuters.

Product support is another factor in upgrade cycles. Most software companies offer product support services in the event of problems. This is especially important in the enterprise market. No company will pay thousands, if not millions, of dollars for software without some form of quality guarantee. However, as new products are released, the cost of supporting older products eventually becomes uneconomical and the firm ends the service. Technology firms can influence their customers to upgrade products and services by phasing out support for older models.

Though Tech has a big US concentration, it is a fully global sector. It's not atypical for firms to derive more than half their sales from foreign markets. As such, currency movements can contribute to sector performance. (For our purposes, because the US represents the largest weight in the Technology sector, we'll focus on the US, though global studies might yield different results.)

Figure 3.9 shows US Technology relative performance and year-over-year percent change in the US dollar versus a trade-weighted foreign currencies exchange rate. The US dollar versus foreign currencies scale has been reversed to better demonstrate the correlation. It certainly is not as strong as some of the previous relationships, with a breakdown in the 1996 to 1997 range. However, there are multiple periods when a weak or weakening dollar has coincided with US Technology outperformance.

On a relative basis, weak dollar environments make US products relatively cheaper in international markets, which can help bolster demand. Moreover, when US-based Technology firms repatriate earnings, there is the added foreign exchange benefit of converting a stronger currency into a weaker currency. Money flows may be responsible for periods where this relationship does not hold. The dollar tends to rise as money flows increase to the US, and foreign money tends to gravitate toward mega cap companies where there is a disproportionate amount of Technology firms. This likely explains the breakdown from 1996 to 1997, when Technology's status as the "hot" sector outweighed the impact of a strong dollar.

Figure 3.9. S&P 500 Technology Relative Performance vs. USD/Trade-Weighted Foreign Currency Exchange Rate Source: Global Financial Data, Thomson Reuters.

Tax policy is capable of materially impacting any company. Simply, the more a firm pays in taxes the lower its earnings, and vice versa. But aside from broad sweeping tax policies that affect all sectors, it is important to examine factors more specific to Technology.

Foreign Income Treatment Many Technology firms today have both domestic and foreign operations. Because product prices tend to fall over time, scores of manufacturers have shifted production to lower-cost regions. These international operations are subject to the local tax code of the country where they're located. But parent companies, again mostly concentrated in the US, face repatriation taxes—funds brought back into the US from a foreign subsidiary are often subject to additional taxes. As such, it's likely the sector would react negatively if the US government forced corporations to repatriate funds or significantly raised repatriation tax rates. This would be a bearish driver.

Capital Gains Capital gains rates also play a role. In general, Technology firms pay less to shareholders in the form of dividends relative to other sectors, leaving higher proportions of retained earnings. Since retained earnings are subject to capital gains, lower rates provide an added boost. For example, in the third quarter of 1997, rates were lowered from 28 percent to 20 percent in the top bracket and 15 percent to 10 percent in the lowest bracket. While other factors were also at play, the Technology sector outperformed the broader S&P 500 Index by more than 40 percent for seven straight quarters (rolling 12-month returns starting in Q4 1998).^[45]

R&D Tax Credits Innovation is central to Technology. In fact, the "Software and Internet" industry ranked highest in 2007 research intensity at 13.6 percent, followed by Health Care at 13.4 percent.^[46] (Research intensity refers to the amount of money firms spend on R&D as a percentage of sales.) Given Technology's heavy R&D spending, any associated tax policies can impact the sector. R&D tax credits have existed in the US (and other countries) for years. The credits are relatively small and, to date, have not had much impact on larger players. However, if these credits were expanded, it would likely be bullish for Technology.

Intellectual property rights are one of the most critical components of capitalism and properly functioning free markets. Without well-protected property rights, firms have little incentive to innovate or take on new projects. Why would Company A spend millions developing a new widget if Company B could copy and sell the exact same widget for cheaper? A lack of property rights, or even weak property rights, eliminates financial incentives tied to innovation.

While individual governments are responsible for local enforcement, global intellectual property rights standards are set by the World Trade Organization (WTO). Note the word "standards"—these are guidelines, not rules. However, changes in these standards and/or country-specific laws can certainly drive Technology.

Technology companies rely on strict enforcement of property rights to protect products, be it hardware or software. Currently, the WTO dictates that patents are expected to last a minimum of 20 years. But if this minimum number of years were dramatically lowered, that could be a potentially significant bearish driver for Technology. Hence, monitoring changes in property rights can be an important step in determining when to overweight or underweight the Technology sector.

Another relevant driver to any global sector is international and domestic trade policies. The accommodativeness and/or restrictiveness of policies often depends on the country and specific products being traded. These laws can provide unfair advantages to some firms and sectors and disadvantages to others, and they can have a sizeable impact on overall sector performance.

The last political driver we'll discuss is government spending. Depending on the country, government spending can have a sizeable impact on Technology demand. Many spend heavily in the areas of defense and communications, but some even spend for public use. For example, to offer nationwide broadband access, multiple countries in Southeast Asia have subsidized network buildouts. Spending initiatives like these significantly impact Technology demand. If large enough, future government spending could be a significant bullish Technology driver.

Through most of Technology's existence, investors have considered the sector a "high beta" play. In other words, during broad market up-trends, Technology is expected to rise more than the overall market, and during downtrends, Technology is expected to fall more. Over time, this has indeed proved true. The Technology sector has a beta of over 1.7 relative to the S&P 500 over the last 10 years and a beta of 1.3 over the last 6 (to remove bubble years)—the highest of any sector over both periods.^[49] This is likely due to the sector's economically sensitive nature. Remember, the market is a leading indicator of future economic conditions. Investors generally believe periods of economic strength will benefit Technology more than the broader market, and periods of weak growth will disproportionately hurt Technology. Hence, Technology tends to move in the same direction as the broader market, though with bigger swings.

Despite Technology's high beta, performance does not always follow this pattern. In investing, nothing is ever black and white. For example, the S&P 500 fell over 24 percent in the beginning of 2009, reaching a new low in March.^[51] But, as shown in Table 3.2, Technology was the best-performing sector over this period, even surpassing traditionally "defensive" sectors like Health Care and Consumer Staples. What explains this? Likely, it had to do with features specific to this downturn—investors panicked over liquidity and stability in financial markets. Companies with high debt loads were punished on fears of potential default. It created a flight to safety where high-quality balance sheets were preferred. This worked to the Technology sector's advantage as it had, in aggregate, one of the lowest average debt loads in the market. Moreover, after the Tech bubble burst in 2000, many Technology firms significantly built up cash reserves. Investors viewed the sector as a safe haven and its traditionally economically sensitive nature was seemingly ignored.

However, in time, sentiment will change again, as it always does. Sometimes investors like earnings consistency, sometimes cash flow. The key is identifying the most important sentiment drivers at a given point in time and whether the Technology sector is positioned to benefit.

Professional forecasts are a way to measure sentiment, and tracking them can provide insight as to what information is or isn't discounted into stock prices. Sentiment bell curves like the ones in Figure 3.10 provide good visual representations. These two histograms show annual market forecasts for the NASDAQ Composite in 2000 and 2001. The largest bars represent ranges with the highest number of forecasts—no bars represent ranges without forecasts.

During this time Technology was widely perceived as the hot sector. Indeed, people felt there was significant risk not investing in Tech. There were millions to be made, and everyone wanted a piece of the action—euphoria was widespread and it seemed the only direction the market could head was up. As seen in Figure 3.10, any sell-off like the one in 2000 was viewed as a simple correction—forecasts for 2001 were extremely bullish.

This, of course, proved false. Ebulliently bullish investors poured money into Technology and pushed valuations sky high. Euphoria blinded investors to the fact that myriad firms had unsustainable business models and weren't even profitable—nor likely to be. Eventually, the bubble burst and those still overweight in Technology suffered dramatic underperformance relative to the market. Massive euphoria about sectors, industries, or even the broad market is almost always a negative future indicator. Identifying such periods can be critical.

Figure 3.10. NASDAQ Annual Market Forecast Surveys Source: BusinessWeek, Thomson Reuters, Fisher Investments.

After the bubble burst, Technology led global indexes into a bear market. But it also led in the ensuing rebound—for a short period. This is fairly common with bear markets. Those sectors hit hardest in the later half of downturns often bounce the most in the early stages of the rebounds. However, the sector that led into the bear—in this case, Technology—may get an initial "dead-cat" bounce and seem like it will outperform the market in recovery. But, historically, those sectors tend to do poorly overall in the ensuing bull market. This is how Technology behaved. After a strong showing in 2003, the sector underperformed in 2004 and 2005. Typically, the biggest sector at the top that does the worst on the way down will drive a psychological overhang. Too much fear about Technology still lingered because investors tend to want to "fight the last war" and avoid the sector that led the last bear market.

Chapter Recap

• Economic growth is the single largest driver of the Technology sector.

• Other economic drivers helpful in predicting Technology performance include fixed investment, component shipments, inflation, share supply, and currency.

• Innovations and upgrade cycles are also capable of driving demand and performance of the Technology sector.

• Taxes, property rights, trade, and fiscal policy represent the largest political drivers of the sector.

• Sentiment has exerted a sizeable impact on the Technology sector's past performance. Examples include its perception as a "high beta" sector, widespread feelings of euphoria, and the mental overhang and risk aversion following the bursting of the Technology bubble.