At the midpoint of 2005 and just ahead of another earnings season, it's time to examine where investors can find the most potential for returns in the second half of the year.

My screening models indicate that the technology sector holds the most promise. I believe that the macroeconomic backdrop, business trends and acquisition action favor tech's chances as well.

Very Undervalued

Gains seen in the Nasdaq and SOX since the April lows point to a rotation into technology, which my models show as the cheapest sector, at 20.9% undervalued. The Nasdaq declined 5.4% in the first half of 2005, but since the April low of 1890, it's up 7.0%.

I have been tracking the Philadelphia semiconductor index for a major, chart-related moving-average crossover, with the SOX off 3.3% in the first half -- but up 11.3% since its April low of 376.64.

According to my models, as the second half of 2005 begins, all sectors are fundamentally cheaper than they were at the end of 2004. As the table below shows, basic industries, energy and transportation ended 2004 more than 20% overvalued. Of these, only energy remains overvalued, but only by 6.3%. The largest swing was in transports, which went from 28.4% overvalued to 5.1% undervalued.

My model shows that technology continues to be where the value has been and should be for 2005. Technology begins the second half of 2005 at 20.9% undervalued, vs. 11.7% undervalued at the end of 2005.

Among my technology indices of focus, computer manufacturers are 31.8% undervalued, semiconductors are 28.0% undervalued, and software is 22.5% undervalued.

In sum, away from technology, most sectors are within 5% of their fair value, with health care 9.3% undervalued and energy 6.3% overvalued. This is a compelling case for focusing on technology in the second half of 2005.

Focus on Tech in Second Half
As the most undervalued sector, it demands the most attention
Sectors Valuation on Dec. 31, 2004 Valuation onJuly 1, 2005
Basic Industries 24.50% overvalued 3.73% undervalued
Capital Goods 17.65% overvalued 4.04% undervalued
Consumer Durables 12.41% overvalued 1.78% undervalued
Consumer Non-Durables 17.34% overvalued 2.46% overvalued
Consumer Services 11.88% overvalued 2.69% undervalued
Energy 22.15% overvalued 6.25% overvalued
Finance 14.44% overvalued 1.00% overvalued
Health Care 1.32% overvalued 9.32% undervalued
Public Utilities 9.02% overvalued 4.63% overvalued
Technology 11.67% undervalued 20.87% undervalued
Computer Manufacturers 31.79% undervalued
Semiconductors 27.97% undervalued
Software & EDP Services 22.48% undervalued
Transportation 28.44% overvalued 5.13% undervalued
Source: Global Market Consultants Ltd.

Economy on Solid Ground

Last week's better-than-expected readings for consumer sentiment and a higher-than-expected reading for ISM tell me that the economy should maintain a GDP growth rate of roughly 3.5% for the foreseeable future. The economy should not be hurt by a 4.25% neutral funds rate, which I predict will be declared by the end of the year, just in time for Fed Chairman Alan Greenspan to be congratulated at his retirement.

Commodities prices appeared stalled last week, but crude oil remains a wild card. With a strong dollar and higher Treasury yields, there could be a rotation into the U.S. equity markets, with technology being the sector of choice.

Tech's Compelling Growth

In tracking technology leadership, my first focus was the chipmakers, but now a major upgrade cycle is needed in the Internet protocol segment. This industry is estimated to have grown by 50% year over year. Retooling the Internet with an expansion of the use of broadband will drive IT spending in the second half of 2005.

In June, the Semiconductor Industry Association reported that chipmakers were quickly working off excess inventory. The trade group predicts sales growth of 6% this year. Both Intel ( INTC) and Texas Instruments ( TXN) were among the semiconductor giants offering positive guidance for the second half of 2005; this backs up the SIA's prediction.

Other growth segments include:
  • WiMax, a version of WiFi, but with an expanded range of some 10 miles.
  • Voice over Internet protocol (VoIP), which gives high-speed Internet providers a triple threat with television service, phone and broadband Internet access bundled into one package.
  • Growth in the use of cell phones, with Nokia ( NOK), the industry leader in handsets, predicting a 15% growth rate for 2005 over 2004.
  • A PC upgrade cycle, which will be driven by dual-processor components, which are necessary to handle the multitasking that the new Internet will provide.

Growth Through Acquisition

The acquisition game should continue in the second half of 2005. Oracle ( ORCL) is successfully integrating PeopleSoft into its stable of enterprise software applications, and it has more money to spend. Symantec ( SYMC) just completed the purchase of Veritas ( VRTS), combining security software and enterprise applications.

Cisco Systems ( CSCO) has continued acquiring smaller companies, but a rumor surfaced last week that its next deal could be a blockbuster: the purchase of storage giant EMC ( EMC). Sun Microsystems ( SUNW) is in the process of purchasing StorageTek ( STK) with the strategy of becoming an IT consolidator and targeting the major data centers around the world. Finally, there's Time Warner ( TWX) and the question of what to do with its America Online unit.

I am covering all of this in Technology Report, through which I keep individual investors informed about investing opportunities related to new technologies, including music downloading and satellite radio.

To learn more about my screening models, read my guide. My models can be applied to any tech stock in your portfolio; if you'd like me to screen your tech holding, please email me the symbol and I'll try to get to it.

My next column will focus on the semiconductor industry, and in subsequent columns I will cover computer manufacturers and software companies. As quarterly earnings stream in, I'll present my models' profiles on each week's key stocks.

Richard Suttmeier is president of Global Market Consultants, Ltd., chief market strategist for Joseph Stevens & Co., a full service brokerage firm located in Lower Manhattan, and the author of Technology Report newsletter. At the time of publication, he had no positions in any of the securities mentioned in this column, but holdings can change at any time. Early in his career, Suttmeier became the first U.S. Treasury Bond Trader at Bache. He later began the government bond division at L. F. Rothschild. Suttmeier went on to form Global Market Consultants as an independent third-party research provider, producing reports covering the technicals of the U.S. capital markets. He also has been U.S. Treasury Strategist for Smith Barney and chief financial strategist for William R. Hough. Suttmeier holds a bachelor's degree from the Georgia Institute of Technology and a master's degree from Polytechnic University. Under no circumstances does the information in this commentary represent a recommendation to buy or sell stocks. While he cannot provide investment advice or recommendations, he invites you to send your feedback -- click here to send him an email.

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