After weeks of blithely ignoring fundamentals, it may be time for investors in semiconductors and chip equipment to get real and prepare for an approaching selloff.

For the past two months, slap-happy equity owners have seized on positive economic reports, eager for signs of impending demand growth. Yesterday, Lehman' upgrade of Intel ( INTC) likewise boosted sentiment, citing evidence of business stabilization in the U.S.

But though the signs of economic firming are encouraging, tech outfits are hardly expecting an upturn next year to shoot the lights out. After weeks of powerful trading gains, shares are now pricing in a recovery far more robust than what's likely to occur. And while December nearly always hosts a rise in chip stocks, there's reason to believe the rally in chips will crumble over the next month or so.

In the near term, Intel's midquarter update this Thursday could support recent gains, because the company is considered likely to tilt revenue and margin guidance upward. (Conversely, if Intel fails to deliver, expect investors to get in a snit.)

But in the next couple of weeks, prepare for choppier markets. Patrick Adams, manager of the ( CHLAX) Choice Long-Short fund, is gearing for a "nasty" Nasdaq slide in the next month, citing the growing disparity between valuations and still-weak tech fundamentals.

Since bottoming at 223.88 Oct. 9, the Philadelphia Stock Exchange Semiconductor Index has risen more than 67%. Yet it's already clear the chip rebound will be a weak one. Consider that the industry has historically grown at closer to 15% a year, but after repeated downward revisions, analysts now reckon chip sales will grow at only around 10% during next year's so-called recovery.

Too Rich?
Chipmakers and equipments sporting heady valuations
Stock Price Rise Since October 8 Consensus Outlook for Sales Growth in Upcoming Fiscal Year Current Forward P/E
Intel 59% 4.6% 36
Xilinx 76 17 36
RF Microdevices 127 20 58
Texas Instruments 41 7 71
Applied Matterials 62 -.20 34
Source: Baseline, Thomson Financial/First Call. Based on Monday's closing prices.

"My opinion is we've seen a 180-degree change in sentiment and attitude in a very short period of time, and not a whole lot has really changed in terms of fundamentals," Adams says. "I don't think there's a lot of risk in shorting the stocks."

Adams is shorting premier chip names, such as Analog Devices ( ADI), Xilinx ( XLNX) and RF Microdevices ( RFMD).

Take Xilinx, which trades at 36 times its '04 earnings outlook of 68 cents, according to First Call.

"I think there's a lot of built-up expectations in Xilinx now. It will take a few years for them to get back to what they earned in 2000," says Adams. At 36 times '03 earnings, Analog Devices also looks too pricey for its outlook; the same goes for RF Microdevices, at 44 times. Adams hasn't shorted Intel, because it may give mildly upbeat midquarter guidance later this week, but he's considering taking profits in it.

Intel has seen its shares rocket by nearly 60% in the past eight weeks. Based on Monday's close of $21.05, it now changes hands at a far-from-cheap 36 times consensus estimates for 2003 earnings. That's well above its long-run average P/E of around 23 or 24, says Sanford Bernstein's Adam Parker.

Meanwhile, Street analysts expect the company to post growth of a mere 4.6% next year. In other words, Intel is trading well off its historic P/E midpoint, leading up to a recovery that should be modest at best.

For that matter, some would argue Intel deserves a lower multiple than in the past. Parker, who downgraded the stock to market perform last week, says Intel should trade for less due to its "contracting margins and decelerating sales growth."

"Only 20% of the time in the past 10 years, including the bubble, did we pay more for Intel relative to the S&P than we are right now," he wrote in a research note.

Though Intel could get a bigger lift next year if corporate profits improve enough, surveys show computer hardware isn't a top priority for IT managers. And the longer-term forecast for Intel's core market (some 80% of revenues) can fairly be described as dim: PC microprocessors are expected to grow at less than 6% a year through 2006, according to IDC.

To be fair, Intel has a weaker outlook than chip names in other areas, such as analog and wireless. But the near-term takeaway is similar, Parker believes: The prospects for a significant rally in December aren't promising. That's true, despite the fact that over the past 30 years, chip stocks have risen 80% of the time in the final month of the year.

He recommends being underweight the semiconductor sector in time for the Q4 earnings releases in mid-January.

For one more example of shaky valuations, consider Applied Materials ( AMAT). At $16.79, it likewise trades at 34 times the 2004 fiscal year consensus estimate for a 50-cent profit.

That's a stretch, says Susan Crossley, a semi-equipment analyst at Wells Fargo who believes a P/E multiple of about 18 times normalized earnings is more fitting for Applied Materials. Her firm has no banking relations with the company.

"My view is that these stocks are trading more and more like the traditional cyclicals that they are, and they should," Crossley says. "In other words, they're tech in name only."

For that reason, rather than valuing the stocks on their peak earnings potential, she estimates fair value based on average earnings over the course of an industry cycle. Applying a multiple of 18 to what she calls a "generous" average three-year profit estimate of 70 cents a share, Crossley ends up with a stock price of $13 for Applied Materials.

"There are some signs of life in the equipment sector , but I don't think next year's going to be stellar in terms of industry fundamentals. If I owned the stocks, I would start to trim them now and ride the rally out through the end of the year," she says. "I would have wound my position down by the end of the year.

"Basically, I think that between now and the end of the year, they're going to keep running," says Crossley. "The hedge funds, all the momentum money, want a good year, want the stock market up. But look out come January."

The January effect is a typical new-year rise in the market that's usually chalked up to some combination of buying optimism and mutual fund inflows. In 2003, it may well prove a bust, given the generous strides stocks already have made.

"I think we've seen the typical January effect happen in October and November," concludes fund manager Adams.