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The big question humming through the tech investing world this month is whether semiconductor companies -- which are down about 25% this year but have rallied recently -- are finally cheap.

The answer from this corner of that world is that while a few chipmakers are close to troughs in valuation, as a whole the group is still richly priced. The main reason is that 2005 earnings estimates on most of the companies are probably too high, making them only seem inexpensive on a forward price/earnings basis.

Giving solace to bulls has been the oddly positive trading reaction to recent lousy earnings guidance from leading chipmakers National Semiconductor ( NSM) and Broadcom ( BRCM). The Philadelphia Semiconductor Index (SOX) is up 10% in the past week on a bout of short-covering and wishful thinking. When stocks go up on bad news, traders tend to think they're sold out.

Tech investors have been burned by a couple of powerful up moves in the chip group this summer, though, and the fate of this move is likely to be similar, but with an evil twist: It should last longer but end the same.

For some data on this, I'll look at a report published Monday by Merrill Lynch analyst Joseph Osha and offer my own calculations.

Osha argues that investors today should focus on buying semiconductor companies at trough valuations because industry revenue is set to contract sharply in the next 18 months. He estimates sales will grow by just 6% in 2005, following a 31% advance in 2004. Profit margins for most of the major companies are near historic peaks already, he says, and unlikely to expand.

And yet very few semis are at anything near trough valuations either on a historical or forward-looking basis. That's why a short-term trading rally of two to six weeks, sparked by optimism for the seasonally strong fourth quarter, will probably run into a wall of reality as companies announce better times are just not in the cards.

LSI Logic's ( LSI) report Monday night typified the stunning crisis for chip sales. The manufacturer of integrated circuits for communications devices revised revenue estimates for the third quarter to $370 million to $400 million from $435 million to $465 million. That amounts to a quarter-over-quarter decline of as much as 17%, rather than the typical second-to-third quarter revenue increase of around 10%. Executives blamed the shortfall on too much inventory in the supply chain, and that is a problem that could take more than three months to work out.

LSI is not some Johnny-come-lately, new-age chipmaker. It pioneered the application-specific integrated circuit industry more than two decades ago, has $2 billion in market capitalization and employs over 4,000 people. And yet it cannot get out of its own way. Based on the guidance and other industry trends, Merrill Lynch now estimates revenue in 2004 will be flat with 2003, and 2005 will be flat again. The stock, which was recently trading within a hair's breadth of its 2002 bear-market low of $4, may well trespass that ugly border in coming days or weeks.

How about the rest of the group? Osha notes that even on existing earnings estimates chip stocks are, on average, trading at a 30% premium to the S&P 500, at 22 times next year's earnings, compared to 16 times for the broad market. He concludes that investors should expect the industry's valuation premium to contract, rather than expand, during the next several quarters as chip companies' earnings estimates follow LSI Logic's path of decline.

Some Short-Term Trades Exist

Trading is very often a game of relative, not absolute, value and many investors may wish to buy some chips now for a quick hit that may not give them a hangover if they decide to hold into next year. To investigate that idea, I screened for semiconductor stocks with measurable price/earnings multiples in the current year and past one to five years. I then calculated the discount of the current multiple vs. the prior year and five-year average multiple, and then ranked them by their MSN StockScouter ranking, a 1-10 scale that has proven its merit in the past three years.

The earnings-positive chip and chip-equipment makers with the greatest current P/E discounts and above-average StockScouter scores are listed below. It's not that these are cheap, necessarily, it's just that they're a lot cheaper than they have been.

Chip P/E Discounts: Are They Enough?
Company Name Symbol PE Current PE 1 Yr. Ago 1 Yr. Discount PE 5-Yr Avg. 5 Yr. Discount SS 9/12 Price
QLogic QLGC 21.5 42.8 -49.80% 69.9 -69.20% 10 $29.88
Linear Technology LLTC 35.5 51.9 -31.60 48.4 -26.70 8 36.92
Xilinx XLNX 28.9 81.9 -64.70 -- 8 29.19
Intel INTC 18.7 52.5 -64.40 59.1 -68.40 7 20.80
Analog Devices ADI 27.6 61.4 -55.00 56.6 -51.20 7 37.85
KLA-Tencor KLAC 32.9 80.8 -59.30 44.4 -25.90 7 39.81
Varian Semiconductor VSEA 29.8 127.7 -76.70 -- 7 32.66
Taiwan Semiconductor TSM 22.4 75.5 -70.30 62.9 -64.40 6 7.62
Power Integrations POWI 33 76.3 -56.70 56.6 -41.70 6 22.44
Altera ALTR 33.5 73.2 -54.20 -- 6 20.35
Source: MSN Money

The ones ranked 8 and higher by StockScouter should have at least a fighting chance to sustain any potential near-term rebound over the next six months. Tomorrow I'll focus more on group leader QLogic ( QLGC), a maker of devices for storage networking.
At the time of publication, Markman was long QLogic, although positions may change at any time.

Jon D. Markman is publisher of StockTactics Advisor, an independent weekly investment research service, as well as senior strategist and portfolio manager at Pinnacle Investment Advisors. He also writes a weekly column for CNBC on MSN Money. While Markman cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at jon.markman@thestreet.com.