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A Hard Choice in Software Games

Confusion over consoles could drive gamers to their PCs, and THQ offers the best holiday season bet.

This column was originally published on RealMoney on Oct. 2 at 12:30 p.m. EDT. It's being republished as a bonus for TheStreet.com readers.

Video-game stocks perked up in the third quarter after a steep downturn knocked the wind out of the entire sector.

Respectable sales for

Microsoft's

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new generation Xbox 360 and growing speculation about the upcoming

Sony

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PlayStation 3 release have speculators believing the cycle has finally turned for this troubled industry.

I've documented my outlook for gaming stocks several times this year.

Most recently, I wondered if the high price tag of the new Sony product would encourage addicted gamers to find cheaper alternatives this holiday season. That's still an issue, complicated by growing interest in the new generation

Nintendo

Wii, which is also hitting the shelves in coming months.

Notably, the Nintendo unit's price tag will be $300 less than the gold-plated PlayStation 3. This pocketbook divergence will be tough for holiday shoppers to ignore, despite the massive installed base of PlayStation owners.

I suspect we'll see more balanced distribution of console ownership when the 2007 holiday season rolls around.

The emerging battle between new generation consoles paints a mixed picture for video software companies. The competitive sales environment could trigger hardware price wars and increase the stagnant base of addicted gamers. Or this industry food fight might just fracture existing ownership and do little to increase software sales in the long haul.

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Massively multiplayer online role-playing games (MMORPGs) will also impact the entire gaming industry later this year and for the rest of the decade. Category-killer

World of Warcraft's

eagerly awaited expansion pack

The Burning Crusade

is scheduled to be released right at the height of this year's holiday shopping season.

Don't underestimate the booming MMORPG industry.

WoW

now has more than 7 million subscribers worldwide paying monthly fees to Blizzard Entertainment, a division of

Vivendi Universal

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. In fact, it's the most popular game in Asia since

Pac-Man

, and has now added more than $300 million in profits to Vivendi's bottom line.

Second-tier software makers have taken notice and are preparing a variety of offerings based on the MMORPG monthly subscription model. Realistically, the user base for this industry subsector could grow to more than 20 million subscribers in the next two years. That would represent a huge chunk of capital that won't be spent on console-based titles.

Short-term traders, me included, love

Electronic Arts'

(ERTS)

frantic movement, but let's step back and look at the stock from a distance. The first thing you'll notice on the weekly chart is the sharp rally off two-year lows this summer. The second thing you'll notice is that price has gone absolutely nowhere in the last two years.

This seesaw action has given long-term investors sleepless nights and relatively poor returns. While the summer bounce was encouraging, price is now moving into broad 2005 congestion, where it could be stalled indefinitely. For this reason, I wouldn't initiate a new position in either direction at this time.

Instead, let's wait out the 2006 holiday season to see whether the fourth quarter shows real and sustained growth for this industry leader.

Activision

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shows price action similar to Electronic Arts', with a sharp recovery off deep summer lows. Note how the stock has retraced all the way to resistance at the November 2005 gap down. This is an obvious reversal zone where price could roll over and head back to the 200-day moving average at $13.

I don't see much downside after the next pullback, but that doesn't make this stock a good buy either. In a nutshell, it looks like price is caught in a sideways pattern that probably won't reward investors until 2007 at the earliest. In the meantime, folks committed to sector exposure should take their money elsewhere.

THQ

(THQI)

looked great in April, but the spring downturn triggered second thoughts in

my June column. The stock began a solid recovery run about a month later, like the other gaming issues discussed today. But its current positioning makes it far more bullish than the competition, with price now at a multiyear high.

Unfortunately, now isn't the best time to buy, because price looks overextended and ready to pull back. This is supported by a possible rollover in stochastics just when the uptrend should be gathering steam. This warns that a corrective phase could begin at any time. But in contrast to other gamers, the next selloff in THQ should offer a good buying opportunity.

Could the stock run here, without pulling back first? Of course, but the more likely scenario would be a pullback to the 50-day moving average at $26.50, followed by a sideways consolidation lasting one to two weeks. That basing phase could set the stage for a bullish surge over the recent high that's sustainable well into the holiday season.

At the time of publication, Farley had no positions in the stocks mentioned, although holdings can change at any time.

Alan Farley is a professional trader and author of

The Master Swing Trader

. Farley also runs a Web site called HardRightEdge.com, an online resource for trading education, technical analysis and short-term investment strategies. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Farley appreciates your feedback;

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