IYW: Slowdown in Consumer Spending a Risk to Further Tech Gains

by: Don Dion

Even prior to the housing and credit crunch that led to a Fed rate cut on Sept. 18, technology stocks largely outperformed the broader market this year. On July 19, for example, iShares Dow Jones U.S. Technology (NYSEARCA:IYW) was up 15.2%, nearly six percentage points better than the S&P 500.

That trend’s continued since, with IYW (through Monday) up more than 16.2% for the year versus 8.5% for the S&P. Between the sector’s strong fundamentals, its apparent insulation from subprime and credit troubles, and its exposure to growing overseas markets, investors have looked to tech stocks in droves for the first time since the sector’s downturn from 2000 to 2003.

The three technology-focused funds in the ETF Momentum Tracker list have been lumped just beneath our portfolio holdings for some time. Last week, IYW edged up to No. 11, marking the fifth straight week it jumped one or two spots. If tech shares continue to rally, it stands to reason that IYW or one of its tech brethren may make a move into the portfolio.

IYW tracks the technology allocation of the Dow Jones U.S. Total Market Index, a market-weighted bogy that heavily emphasizes the larger firms with proven track records that many analysts are advocating. The ETF’s top 10 holdings, which account for nearly 59% of its assets, read like a list of the tech’s biggest bellwethers.

Those firms tie in to the sector’s strengths: First, new technologies and the movement toward pushing video to PCs and wireless devices has aided everyone from product providers (such as Apple) to networking firms (such as Cisco).

Second, the sector’s biggest firms enjoy strong demand from faster-growing economies outside the U.S., especially in emerging markets. Of the 10 major sectors tracked by S&P, only energy derives a higher percentage of revenue from outside the U.S. That strength has only been magnified by the weak dollar, which has helped lift profits from abroad while allowing U.S. companies to keep competitive against non-U.S. firms.

No. 2 holding Cisco Systems (NASDAQ:CSCO), for example, has seen order-growth approach 50% in emerging markets, compared to the upper teens in the U.S. Cisco shares jumped 19.1% over the past three months.

Add to that a slew of M&A, share buybacks, healthy balance sheets from wiser spending in the wake of the long tech downturn, and even dividends from some of IYW’s key names, and 2007 has seen a strong tech rally that, so far, continues through the market’s bumpiness. Corning, the No. 14 holding, with share prices up 34.6% year to date, is the latest tech giant to initiate a dividend.

Recently Scott Kessler, head of S&P Equity Research’s tech group, pointed to all the above reasons for tech’s strength. He also cautioned that slowing economic growth left him neutral on the group. Still, he pointed to 11 stocks that S&P likes in the sector, including IYW’s top holding, Microsoft (NASDAQ:MSFT) (down slightly in 2007 but near post-2002 highs), No. 3 (NYSE:IBM) IBM (up 22.8% YTD), No. 4 Intel (NASDAQ:INTC) (up 30.8% YTD), and five more of the ETF’s top 14 holdings.

Some bulls point to some evidence from The Wall Street Journal that “growth” stocks, such as tech, tend to outperform “value” names after rate cuts. In the six months following each of the last seven rate-cutting periods since 1974, growth stocks in the S&P 500 averaged a 14.8% return versus 8.8% for value stocks.

The Journal also noted recently that growth-stock funds have de-emphasized tech stocks lately, which may be a sign they’ll be buying going forward. Such funds held an average of 26.5% of assets in tech over the last 10 years, but recently that figure stood at 22.6%, lower than at the start of 2005.

Whether the tech rally continues will likely depend on how much the financial sector’s issues impact the economy. Financial companies have been some of the biggest spenders on technology, and if that spending slows, even the big boys of tech could feel some pain.

When No. 8 IYW holding Oracle (NYSE:ORCL) (shares up 27.1% YTD) released earnings on Sept. 20, broad-based growth did not show a slowdown, even though financial firms are key customers.

A true slowdown in consumer spending for gadgets and cutting-edge wireless devices could hurt tech stocks too. And with earnings season dawning, evidence of such a trend could present itself soon.

That’s the key risk to IYW right now, aside from the usual sector risk and single-stock risk from a concentrated portfolio: Widespread economic difficulties could quickly reverse the gains tech stocks and the ETF have made. Still, as a potential niche holding in a diversified portfolio, IYW’s focus on tech giants could help it survive and maybe even push its way further up the Sector Momentum Table.