How to Survive a Recession

LESSON 26: Get Out and In Early with Technology Investments

The technology sector tends to be a leading indicator for the state of the economy and the stock market. Technology includes computer hardware, software, semiconductors, telecommunications, networking, engineering and design services, contract manufacturing, and research and development services.

Why is technology a leading indicator? The answer lies in how technology companies are valued. Technology companies generate profits by converting intangible assets and intellectual property (IP) such as computer code, designs, patents, and skilled engineers into products and services for customers. The majority of a technology company’s stock value resides in the future promise of converting its IP into cash flow. Technology investors expect those IP-generated future cash flows to grow at an exponentially high rate if the company’s product or service is successful.

Once a technology is developed, delivery costs as a percent of revenue drop dramatically, creating gross profit margins of 100%, 200% or more until competition drives down prices. If the technology is successful, investors hope sales will skyrocket and drive up the value of the company exponentially. All of this hinges on future sales prospects and the built-in gross margin leverage of technology. When either of these factors begins to change, technology stocks react more quickly than other industries.

As the economy slows you should plan to get out of your technology investments soon. commercial customers begin to reduce their purchasing of major information technology projects and new software packages. Consumers slow their purchasing of new personal gadgets. Customers have already purchased what they need during the previous economic boom, so demand falls off quickly. Yet product development lead times mean technology companies are still spending large amounts of cash developing products that have not generated sales yet. Falling revenues and continuing development costs cause near-term expected cash flows to drop rapidly. Major institutional investors pull their capital out of the technology sector, resulting in significant stock price drops.

The reverse dynamic also occurs towards the end of a recession, with the technology sector leading the economy upwards. During recession years, corporations, governments, and consumers reduce their purchases of technology products and services. They continue to use existing technologies as long as possible until they are fully depreciated or their benefits are insufficient to meet new needs. It takes approximately 3 to 5 years between the time a personal computer, cell phone, or software package is purchased to the time it becomes fully depreciated or outdated. This is much shorter than fixed assets such as buildings or machinery.

Given the tax incentive created by depreciation rules and new product life cycles, new technology replacement tends to occur quite early. If the recession is extended, this “need to replace” dynamic can create pent up demand that is released when the economy begins to recover. This causes technology sales to recover earlier than other industry sectors toward the end of a recession. Large institutional investors begin heavy buying of technology stocks in anticipation of rapid near term revenue growth. This pushes technology stock prices up before other stocks react to improving economic conditions, making the technology sector a leading indicator.