There Is a Method to the Rally's Madness

On the surface, there's a huge disconnect between the performance of many tech stocks and their underlying business fundamentals. Second-quarter earnings in the sector have beaten lowball estimates, but overall company guidance has been squishy at best.

Executives at industry titans Microsoft (MSFT Quote - Cramer on MSFT - Stock Picks) and Intel (INTC Quote - Cramer on INTC - Stock Picks) undermined hopes for a robust second-half recovery in IT spending, as did CEOs at varied other tech shops, including KLA-Tencor (KLAC Quote - Cramer on KLAC - Stock Picks), STMicroelectronics (STM Quote - Cramer on STM - Stock Picks), Siebel Systems (SEBL Quote - Cramer on SEBL - Stock Picks) and Storage Technology (STK Quote - Cramer on STK - Stock Picks).

Meanwhile, sector bellwethers such as eBay (EBAY Quote - Cramer on EBAY - Stock Picks), Texas Instruments (TXN Quote - Cramer on TXN - Stock Picks), Qualcomm (QCOM Quote - Cramer on QCOM - Stock Picks) and Novellus Systems (NVLS Quote - Cramer on NVLS - Stock Picks) lowered third-quarter guidance while IBM's (IBM Quote - Cramer on IBM - Stock Picks) results were bolstered by currency translations and gains from acquisitions.

Firms such as Nokia (NOK Quote - Cramer on NOK - Stock Picks) and Broadvision (BVSN Quote - Cramer on BVSN - Stock Picks) couldn't hide disappointing results.

Nevertheless, the Nasdaq Composite is still up 27.4% year to date while a purer tech gauge, the Merrill Lynch Tech 100, is up 34.2%. Both indices are also up for the month, despite Thursday's broad-market reversal, and are outperforming the S&P 500.

All of this is maddening to skeptics, who say strength in tech stocks is proof that wild speculation and blatant disregard for fundamentals still run rampant. It's as if few investors learned anything from the aftermath of the 1990s stock market mania, say naysayers.

The bears may yet be proven right, as they were after the market's peak in 2000. But optimists claim there are explanations for the rally that go beyond pure animal spirits. Their rationale for recent strength in tech shares, and optimism going forward, can be broken into three major categories: results, leverage, and the gaming of guidance.

Strength in Numbers

At midweek, 31% of companies in the S&P tech sector had reported quarterly results, besting consensus estimates by an average of 4.5%, according to Diane Garnick, chief U.S. portfolio strategist at Dresdner Kleinwort Wasserstein. That performance isn't shocking, given that expectations for the sector had been thoroughly degraded. More surprisingly, tech firms reported 6.8% sales growth while their expenses have risen by 3.3%, Garnick noted.

In other words, this notion that bottom-line earnings growth is being produced mainly via cost-cutting while revenue growth languishes is not backed up by second-quarter results to date.

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