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The recent troubles of internet stocks tempt you to blame day traders. But the real culprit isn't someone who's too quick on the draw with his computer mouse. It's interest rates. Net stocks move up and down, tracking changes in interest rates, just the same as bonds, but their swings are even larger. Both the Fed and the European Central Bank are currently considering rate increases. That's why tech investors should watch the Federal Reserve with even more interest than their fixed-income counterparts. This rate-related phenomenon stems from a basic similarity between Net stocks and bonds: Both demand you stick around for a long time for the ultimate payoff. This all relates to a concept called duration--which measures how long an investor must wait to get paid for making his investment. More precisely, duration is the weighted average time for the dollars to return, the weights equal to the net present value of each payment to the investor. The longer and more back-loaded the stream of payments, the higher the duration. The duration of a one-year bill is simple--one year. And the duration of a 30-year zero coupon bond is 30 years, since it makes only one payment to the investor at maturity. But the duration of a 30-year bond (at today's interest rate levels), paying interest at six-month intervals and repaying principal after three decades, is about 13 years, since so much of the value is represented by the interest payment in the early years, and the present value of the distant principal payment is so small. Duration also measures the sensitivity of bond prices to a change in interest rates. If interest rates rise by one point across the yield curve, for example, the price of a bond with an 11-year duration will fall 11%, while a 30-year zero's price will fall 30%, roughly speaking. Now let's turn to stocks, which represent a claim on a stream of future free cash flow, just like the coupons on a bond. And you can calculate a duration for this income stream, too, in just the same way, using estimates of free cash flow in place of bond payments. Stocks must have longer duration than bonds for two reasons. They have no maturity dates: In principle their cash flow stream goes on forever. And, unlike bonds, their payouts to investors should grow over time as profits increase. The Standard & Poor's 500 duration, for example, is maybe 25 years (depending on some assumptions about growth and appropriate discounting rates), about double that of the long bond. This means that stock prices are twice as sensitive to interest rate changes as long-term bond prices. When the Fed tightens, investors often pile out of stocks into bonds to take advantage of the sweet rates. Stock prices tumble. That really hurts Internet stocks, which for the most part have yet to start producing free cash flow. These stocks have the longest durations of all, perhaps 30 to 50 years. This means that a one-point move in long-bond yields will whipsaw Internet stock prices by 30% to 50%, as we saw earlier this year. That leads to a bizarre rhythm in the market and an interesting opportunity for tech stock investors who pay attention to the economy. The technology boom, as I discussed in a previous Forbes.com article, has created an economy that has confounded the Fed. For the past four years the economy has grown about 4% per year, about twice as fast as the Fed's economists thought it would. The Fed, using the discredited Phillips Curve model, thinks more growth means higher inflation. Every time a big growth number is released Alan Greenspan makes noises about irrational exuberance and scares bond market investors into selling long-term bonds. This talk pushes interest rates up and Net stock prices down. But the technology boom also pushes product and service prices lower for all companies in the economy. This is taking place directly, as computing costs fall to reflect Moore's Law, and indirectly, as the Internet flattens prices and squeezes margins for middlemen everywhere. As a result, over the past four years, inflation has been only half the level economists thought it would be. This has created a wonderful trading opportunity for tech stock investors to buy on weakness every time the Fed worries about excessive growth leading to rising inflation. And it makes Internet stocks the weapon of choice for investors--like me--who want to bet that interest rates will come down.
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