Tech Recovery Is Plagued by Potholes

The always nerve-racking tech stock roller coaster is going to get even wilder in the next few quarters.

Despite unusually strong first-quarter results, and plenty of evidence that the recovery in IT spending is real, technology stocks have struggled since late January. But although valuations have declined significantly as a result, there seems to be no immediate catalyst to spark a rally, and the sector is likely to be buffeted by the dollar's comeback and uncertainty about rising interest rates.

"We had expected a rally now followed by weakness later in the year. But many stocks are breaking 150-day moving averages -- if we don't see strength soon, tech will be back in a bear market," Merrill Lynch's Steve Milunovich wrote earlier this week.

Although the "bear" terminology isn't being used frequently, traders aren't acting like technology companies have been making their numbers, much less besting them. The Nasdaq Composite and Goldman Sachs Software Index are each down about 3% year to date, while the Philadelphia Semiconductor Index is down about 13%. By comparison, the S&P 500 is up about 1%.

Tech-stock weakness has recently accelerated amid the generally positive first-quarter results. One notable exception: Microsoft(MSFT Quote). After a prolonged period of underperformance, the software giant's stock is up about 5% in the last few weeks, an indicator investors are seeking safety.

"We've seen a move away from high-beta stocks in the last six weeks; in telecom equipment, particularly Nortel (NT Quote) and Nokia(NOK Quote), it has become a rush," said John Rutledge, who manages the (ETCAX Quote)Evergreen Technology fund.

The ensuing tech correction has deflated forward price-to-earnings ratios by about 10%, meaning that shares are now trading at approximately 19 times 2005 estimates, a historically low level, said Vadim Zlotnikov, chief investment strategist at Sanford C. Bernstein.

The tech sector's forward P/E compares to 16.5 times 2005 estimates for the S&P 500, a relatively modest spread considering Nasdaq 100 earnings are expected to grow 39% in 2004 and 22% in 2005 vs. 11% and 9%, respectively, for the S&P 500, according to Baseline.

"I think tech valuations are good where they sit now," said Tony Ursillo, an analyst with Loomis Sayles & Co., adding that by measures other than P/E -- particularly free and discounted cash flow -- some companies that might seem a little rich are, in fact, good buys. Companies he mentioned with strong cash positions include Microsoft, Adobe (ADBE Quote) and Oracle (ORCL Quote).

However, any valuation improvement amid recent weakness has not spurred renewed interest in semiconductor and equipment stocks, as that industry is apparently hitting a cyclical peak.

"The real money to be made in deep cyclicals like semis was when things looked bleak about a year ago. It's hard to [make money] at this point in the cycle," said Chris Casey, head of portfolio management at Boston Private Bank, an investment management firm with $1.95 billion in assets.