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Monday Morning: Techs drag down S&P 500 and the Dow

It appears the unheeded predictions of many that the tech stock bubble would eventually burst have come true.

It appears the unheeded predictions of many that the tech stock bubble would eventually burst have come true. The Nasdaq Composite Index has almost collapsed, and it appears to be dragging the Standard & Poor’s 500 stock index and the Dow Jones Industrial Average down with it.

That should be no surprise, because revisions to both have added significant technology to them, and the market appreciation of tech stocks in the past two or three years pushed the tech weighting even higher, at least for the S&P 500.

How far will the correction in tech stocks go? Research by Ken Safian, president of Safian Investment Research in White Plains, N.Y., may provide a clue.

Mr. Safian, a veteran researcher who with the late Ken Smilen first divided stocks into growth stocks and cyclical stocks, took a look at two similar bubbles – the railroad bubble and the electricity bubble. They are remarkably similar to the technology bubble in many ways.

For example, in the 1860s, the railroads were building networks – rail networks. And during that time the railroad stocks surged. The rate of increase in the prices of railroad shares far exceeded the rate of growth of the networks themselves.

The S&P Railroad index surged almost 350% between 1865 and 1870 before beginning to slide. During the same period, the miles of track increased by only 50%.

In the early 1920s, the electrical utilities were building power networks. Between 1922 and late 1928, the prices of the S&P Utility index surged to about 58, from about 13, almost 450%, while during the same period net production of electricity just about doubled.

Now let’s look at the tech boom. The Safian Technology Average is an index that has captured the stock price movement generated by the tech boom.

Since 1994 the Technology Average has boomed more than 1,000% while technology-oriented new orders in dollar terms have increased only a little over 100%.

The parallels are eerily similar. Can the history of the railroad and electricity booms tell us what to expect now that the tech bubble seems to have burst?

In the case of the railroads, the railroad stocks plunged after 1870, with the railroad index dropping so far that by 1877 it was up only about 60% over its 1865 level, and that was below the actual growth of miles of track.

Not until 1880 did the rate of increase of stock prices catch up with the growth of track miles.

In the case of utilities, after the stock price peak in 1928, utility stock prices dropped, until 1935 when their rate of growth was behind that of the growth of the production of electricity.

This does not augur well for technology stocks. The correction so far has taken technology prices only partway back to matching the growth rate of orders, which implies that there could be further pain ahead for the technology sector.

That in turn implies further pain for the economy as a whole. The collapse of tech stock prices no doubt has made many, many investors feel poorer than they were only a month ago. Much of the consumer spending of the past several years has been fueled by the so-called wealth effect.

If consumers now cut their spending to match the decline in their paper wealth, the economic slowdown could be far more severe than anyone has been expecting. We could be in for a significant recession.

Perhaps our best hope is that, as John Maynard Keynes said, history repeats itself, but not exactly.

Let’s hope the “not exactly” means that tech stocks correct less than the railroad and electricity stocks did after their bubbles burst, and so the collateral damage is less.

But if the bursting of the tech bubble mirrors the earlier two, hold on to your hats. We have a ways to go yet.

Mike Clowes is the editorial director of InvestmentNews.