Is This Tech Rally for Real?


By Amey Stone Investors taking their cue from stock charts might assume that a major tech bounce back is under way. The tech-heavy Nasdaq composite index has risen nearly 30%, to 1,424, from its low of 1,100 last October. About six percentage points of that gain has come just since the start of April.

Sounds impressive. But the truth is this may not reflect a genuine tech recovery -- yet. Tech investors are doing a good job making the most of a few positive indicators and may even be able to breathe a recovery into life. Because a buoyant stock market provides economic fuel, the current rally could well prove a self-fulfilling prophesy.

Nonetheless, it's worth noting that if you define a tech recovery to mean chief information officers are actually spending more on technology software and equipment, that's not happening. Most surveys of tech buyers show that they don't have any plans to increase spending in 2003. That's a negative many analysts and investors dismiss as a lagging indicator.

NO SALES SPURTS. Still, even the upturn in first-quarter earnings -- which has gotten most of the credit for the recent rally in tech stocks -- isn't that impressive on closer inspection. The 40% of tech companies that have reported so far have beaten estimates by 7% on average (vs. 6% for companies in the benchmark Standard & Poor's 500-stock index). Normally, they beat estimates by 3% or 4%. However, much of the tech-stocks' jump has come because bellwethers Microsoft (MSFT) and Intel (INTC) exceeded estimates (both by 3 cents a share), and those large-caps dominate the sector. In fact, the same percentage of companies are beating estimates as usual -- only about 50%, says Joe Cooper, research analyst at earnings tracker First Call.

Also worrisome: Earnings gains to date have mostly come from companies cutting costs and selling off weak product lines -- not increasing sales. Tech revenues in the first quarter are forecast to be up only 2%, while earnings should be 16% higher. "What you really want to see in a tech recovery is a broad-based group of companies exceeding estimates with a lot of positive outlooks out of companies," says Cooper. "We just didn't get it."

So what's behind the rally? Basically, it's being fueled by a few positive indicators combined with justifiable optimism that the end of the Iraq war and declining geopolitical risk will boost both the overall economy and the tech sector (see BW Online, 4/21/03, "Prepare Now for the Postwar Rebound").

IMPORTANT HARBINGER. "While few CIOs indicate that their spending behavior was changed by the Iraqi war, common sense suggests otherwise," SoundView Technology strategist Arnie Berman wrote in an Apr. 15 report. He also has some telling evidence that the Iraq war, which started Mar. 19, was a factor in tech spending decisions: Software companies, which are the most reliant on late-in-the-quarter sales to make their numbers, had by far the most negative earnings surprises of any tech subsector this quarter.

Berman also points to a recent uptick in the advertising market as proof that companies are already increasing discretionary spending. That's an important harbinger for increased levels of capital spending, which bodes well for a tech recovery, he says. He expects improvement to start to show up in the second quarter.

For other small but telling indicators, some investors point to marked improvement in the semiconductor industry. "Intel makes the microchip of the world," says Pat O'Neil, president of Loring Investment. "They are the bellwether of the capital spending for the production of new technology products." Paul McEntire, portfolio manager of the Marketocracy Tech Plus Fund (TPFQX), has been adding semiconductor names like Linear Technology (LLTC), Maxim Integrated Products (MXIM), and Xilinx (XLNX) to his portfolio.

RISING OPERATING RATES. "I'm optimistic," McEntire says. "I see the relatively quick end to the war, the prospect of lower fuel prices, inventories being worked down, and companies having divested of businesses that weren't making any money, which will lead to a more efficient tech market," he says. Some government numbers buoy his case. High tech's capacity utilization rate rose from February's 61.7% to 62.1% in March. That's "still horrible," notes Moody's Investors Service (from 1993-97, tech utilization averaged 83%), but the fact that it rose at all is a big boost for year-over-year earnings comparisons.

Indeed, the best hope for a tech earnings recovery this year is still due to the benefits of operating leverage -- basically, that compainies will experience a significant jump in earnings, even if sales don't increase that much, since they won't have to increase fixed costs to produce more when demand kicks in. Orders haven't jumped yet, but at least they don't seem to be dropping off anymore.

"Things have stopped getting measurably worse," says Erick Maronak, head of research at investment firm NewBridge Partners. "I wouldn't jump to the conclusion that we're out of the doldrums and everything is going to be a straight moon shot from here. But leading companies that have been weathering the downturn all along are making better progress." He points out that Nokia's (NOK) first-quarter earnings were far better than Motorola's (MOT), and Dell (DELL) had more good news to share than did Hewlett-Packard (HPQ).

Investors hoping to get in ahead of an eventual rebound in tech spending still have a window before the recovery materializes. It's a risky play, and investors will need to choose their spots carefully. But with momentum building, it could prove even riskier to bet against the current tech rally. Stone is an associate editor of BusinessWeek Online and covers the markets as a Street Wise columnist and mutual funds in her Mutual Funds Maven column


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