Midday Musings: Tech May Be Ripe for Rediscovery

Major averages were clinging to what had been decent gains at midday, as weaker-than-expected new home sales were overshadowed by market-friendly testimony (you were expecting something else?) by Fed Chairman Alan Greenspan.

As stock proxies tried to gain some traction in a nascent and still tenuous advance today, the Dow Jones Industrial Average was resuming its place as the market's pacesetter. Since the market's recent peak in early January, the Dow has outperformed broader averages and was up 1% since Jan. 1 heading into today's session. Meanwhile, the S&P 500 was down 3.4% since the beginning of the year, and the Nasdaq Composite was off 9.3%.

Many "stodgy" Dow components such as Alcoa , DuPont and 3M (MMM Quote) have benefited from a combination of investors' desire for simplicity in the wake of Enron's fiasco and evidence the economy is rebounding.

Most forecasters expect the trend of cyclicals showing relative strength vs. growth stocks to continue. But a critical fallibility of many prognosticators is the tendency to extrapolate the past while presumably looking ahead. That said, perhaps the most unexpected outcome of any forthcoming rally -- assuming it continues -- would be one that's led by tech stocks.

But that, indeed, is the expectation of a handful of market participants.

Michael Paulenoff, founder of 2MStrategies.com, expects the Comp to outperform whether the market's next big move is up or down. "If the markets go down, the [Dow Industrials] will be relatively weak," he predicted. "If they climb, the Nasdaq should begin to outperform in the upcoming weeks and months."

A long-term ratio chart suggests the Dow is putting in a "relative peak" vs. the Comp, which should advance as the initial signs of economic recovery are perceived as being "in progress," he said. That progression should prompt money to come out of cyclicals and into tech stocks, which should also benefit from the fact they have been "so beaten down and discredited" that contrarians will consider them attractive.

Paulenoff is a technician, and the short history of our discussions has proved him to be one with a bullish bent. But in recent conversations, some more fundamentally focused money managers made similar observations about growth vs. cyclical stocks.

The semi space "should be a huge beneficiary of the cessation in inventory liquidation" that is likely to occur as the economy picks up steam, said Ed Hemmelgarn, president of Shaker Investments in Cleveland, which has $2.3 billion under management.

An admitted optimist about the economy, Hemmelgarn still believes tech and related communications are going to be the fastest growing sector of the economy in the next 15 years.

Among his recommendations, and long positions, are Xilinx (XLNX Quote), which helped spark the Comp's recent rally by raising its revenue guidance late last week. Other chip names he favors include International Rectifier (IRF Quote) and Microchip Technology (MCHP Quote).

With Xilinx, particularly, the issue of valuation is a concern for many investors, given that the company trades at a price-to-earnings ratio of nearly 106 times expected earnings in the next 12 months. "I don't think it's that expensive early in the cycle," Hemmelgarn argued, forecasting Xilinx will exceed not only consensus expectations, but also its prior peak quarterly profits of 32 cents a share in the coming cycle. "I'm not saying it's dirt cheap, but given where interest rates are at and that people are earning 1.5% in money market funds, [investors will want] a company that can grow like it can grow."

Hemmelgarn is trying to put together a portfolio of "dominant players" in the chip industry. In addition to Xilinx, he mentioned JDS Uniphase (JDSU Quote) in a similar light, saying he would "buy the entire company at this price" if he could. "If you've got a three- to five-year time frame, it's a good stock. I don't think it's going back to $150, but back to $20 seems reasonable."

Hemmelgarn also recommended Peregrine Systems (PRGN Quote)and Retek (RETK Quote), as well as several nontech names, including chemical concern PolyOne (POL Quote).

Shaker Investments' hedge fund product rose by more than 30% last year, but its long-only product fell by more than 20%. I'm not sure when and where the firm bought the aforementioned stocks, so this could be another case of a manager seeking to get out from positions deep underwater.

But even fund managers who are underweight tech, such as Nat Paull, senior portfolio manager at New Amsterdam Partners, agreed that tech earnings can rebound quickly because of the leverage many firms in the sector enjoy. "Just as margins and earnings per share got crushed on the downside, they can rebound quickly," he said.

Again, New Amsterdam, which has $1.4 billion under management and whose equity offerings fell by 8.6% last year, is underweight information technology and telecommunication services, which made up about 23% of the S&P 500 as of Jan. 31.

The problem is far too many investors still have 50% or more of their portfolios in tech and are hoping for a rally to bail them out. But for those truly underweight the sector, now might be a time to consider raising your exposure, presuming you believe the market really is beginning a new uptrend, that is.