TCS Daily


Oil Shock Hurts the Tech Sector Most

By Kevin Hassett - September 25, 2000 12:00 AM

Recent protests in France and the UK reminded us that OPEC can still cause economic harm. News that OPEC will not take steps to increase oil output sent markets into a tailspin, and put enormous political pressure on gasoline-taxing politicians worldwide. In the U.S., the short-term pain has been especially sharp for Nasdaq investors. A couple of weeks ago, the Nasdaq index was above 4200. More recently it's traded as low as 3700, a 12 percent decline in a very short time. Meanwhile, the Dow dropped about 6 percentage points. Economic history suggests that there's a good deal of logic behind this pattern. Understanding it can help you invest in the firms that are least likely to be crushed if the worst happens in coming months.

It doesn't take much imagination to figure out why higher energy prices could upend old-economy firms like GM. GM and its suppliers, after all, turn metallic dirt into automobiles. Smelters and assembly lines require lots of energy. Moreover, higher gasoline prices might undermine the demand for high-margin products such as sport utility vehicles. But how can it be that fears about a renewed oil crisis affect high-tech firms the most?

There are two good reasons. First, high-tech firms consume a lot more energy than you might think. A company like Oracle, for example, with its thousands of computer terminals cranking around the clock, consumes as much energy as a small city. Double the cost of energy, and Oracle's margins will be hit. Of course, that is not much different from the GM story. That doesn't explain why tech stocks are hit harder.

To understand that, we need to look a little closer at what happens when a recession hits. As mentioned in an earlier Greenbook ("The Fed Learns to Stop Bloodletting") oil shocks have preceded almost every recession. In the earlier piece, I argued that academic research has suggested that ill-advised Fed actions helped to push us over the edge into recession, but now the Fed has learned how to avoid making the same mistakes. The last two weeks suggest that the news out of OPEC has been bad enough this time around that a recession could well happen anyway.

Think about it. Americans are looking at a European populace that is practically rioting in the streets, an OPEC that is resolved to maintain the upward pressure on energy prices, and a leading presidential candidate (Al Gore) who has supported higher oil prices in the past. If folks decide to save a little extra, or hold off on the new addition to their home, it might be a sensible caution. If enough people move in that direction, the recession will happen.

If a recession does happen, tech stocks will be hurt the worst. Why? During a recession, business failures increase. Firms that fail tend to come from the set of low-profit firms. Tech firms that don't have earnings, and don't have big cash hordes will be especially close to the mortuary. Normally, when a firm with a good idea but a cash shortfall has trouble, a bank or other lender will step in and provide the cash needed to keep floating. In a recession, however, "credit crunches" can occur wherein lenders, awash in bad loans, only lend to low-risk firms. A wave of bankruptcies can begin, driving firms without heavy financial resources out of the market.

Equity markets can dry up as well, so firms without cash will have no way to meet payrolls, and buy supplies. Which existing firms might feel such pressures? Recent concerns by Wall Streeters that even Amazon.com might have trouble keeping its business going suggest that every firm may be affected.

What should you do about it?

First, remember that timing the market is a bad idea. Nobody knows where things will go in the next few months, and the odds are that anything you sell will be higher in December than it is now. Second, if you are worried about short term fluctuations you might make sure that you own shares of firms that have cash on hand and earnings rolling in. If all of your brilliant tech plays have made you millions, but all of your wealth is in firms that still don't make money, it might be a good time to reallocate. Finally, (and this is what I'm doing) you might decide that the market's fears of oil-induced catastrophe are too pessimistic, and make a few new investments in stocks that have been battered in recent weeks.

And if the worst does happen, and a recession strikes, there is one last thing to remember. A recession is like a forest fire. Many old trees die. But the survivors have lots more room to grow. If you stay invested in firms with a good chance of surviving, you might even come out ahead.
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