Chip investors' faith in a 2002 economic recovery has fueled a dramatic rally in shares of the companies that make semiconductor equipment. Now one analyst is urging a reality check.

Even given the market's strong performance since it bottomed, the rise in chip-gear stocks has been startling. Since Sept. 21, the S&P Semiconductor Equipment Index is up 51.3%, compared with a 17.5% gain in the

S&P 500

.

Some of the wind came out Tuesday when Timothy Arcuri, an analyst at Deutsche Banc Alex. Brown, released 2003 earnings estimates for the group that are on average 25% below the existing consensus. Arcuri cited what he said were unrealistic expectations for a rebound in capital spending.

"My main reason is that 2002 consensus numbers imply too strong of a recovery and a little bit too soon," Arcuri said. "It's really a slope of the recovery and the speed of the recovery issue."

Not All Bad

While cautious on the group, Arcuri said he continues to favor back-end chip-equipment firms such as

LTX

( LTXX) and

Teradyne

(TER) - Get Report

because of superior growth opportunities and cheaper valuations. Arcuri raised his price target on Teradyne to $37 from $32, citing "favorable trade winds" and exposure to clients such as

Cisco

,

Nortel Networks

and

Lucent

. (His firm has done underwriting for LTX.)

Chip-equipment stocks were lately lower.

Applied Materials

(AMAT) - Get Report

was off 1.6% to $42.50, while

Brooks Automation

(BRKS) - Get Report

fell 1.9% to $40.82.

Credence Systems

( CMOS) fell 1.7% to $20.20, and

Lam Research

(LRCX) - Get Report

lost 0.6% to $24.55.

KLA-Tencor

(KLAC) - Get Report

and

Electro Scientific Industries

(ESIO) - Get Report

were also falling.

But climbing on Arcuri's affirmation, LTX inched up 0.3% to $23.15, while Teradyne rose 0.8% to $30.85.

Aiming High

Chip-equipment stocks are a seminal growth play. The stocks tend to be the forerunners of recovery because manufacturers order capital equipment in anticipation of demand. Stocks in the group have soared over the past three months: Lam Research has gained 48.4% since Sept. 21, while Credence has soared almost 79%. Applied Materials has risen 48%.

On Dec. 11, Solomon Smith Barney analyst Glen Yeung raised his price target for KLA-Tencor to $58 from $47, Teradyne to $35 from $25, and Electro Scientific to $35 from $30.

"Given the recent rally in the group, we expect stocks to pull back on a trading basis as fourth-quarter results are apt to show the same weakness already experienced this cycle; we remain positive, however, on the six-month-and-beyond outlook," Yeung wrote in a report.

Three days later, on Dec. 14, analyst David Duley of Wells Fargo Van Kasper initiated coverage on LTX with a buy rating and 12-month price target of $32, arguing that the company can achieve "above-average revenue growth and market-share gains in the next up-cycle for the industry."

Whence the Next Cycle?

According to Arcuri, a watershed event for the new cycle would be for capacity utilization levels to reach 80%. His analysis shows that current capacity utilization levels are at 60%, a low not seen since 1991.

"The issue is how long it'll take for us to go from 60% to 80%, and that's where I differ from the consensus," Arcuri said. "You're going to see modest increases until the end of next year, but current consensus numbers don't imply that."

In light of this utilization deficit, stock valuations are presently too high. Most names, save for Applied Materials and LTX, are trading above their 2000 "bubble" peak multiples, Arcuri said.

"I think those two issues come together and produce an unpalatable witch's brew," he added.