In a sudden transport of emotion -- call it hope, or rank foolishness -- the market has bid up chip-equipment stocks by more than 50% over the past month.

As of Monday's close, the S&P index for the group was up 58% since its early October low, compared with a rise of only 25% for the

Nasdaq

.

But the run-up ignores some resoundingly crummy earnings-season news. Not only are semiconductor companies cutting their capital spending budgets this year, as expected, but they're already hinting spending will be flat to down in 2003. If that comes to pass, next year equipment makers seem destined to watch their sales stagnate, if they're lucky.

And that renders the wild run-up in stock prices all the more bizarre.

At Morgan Stanley, analyst Steve Pelayo speculates that investors have piled into the stocks, aiming "to buy the last piece of bad news," betting the outlook is about to get rosier.

But "they're facing some pretty big headwinds," he says. "Clearly the fundamentals do not support this kind of rally. In 2003 at this point we're looking at flat at best year-over-year

capital spending growth. If you look at the utilization rates of semiconductor companies, they're declining."

Intel to Ratchet Down Capex

Consider the bleary capital spending outlook:

Texas Instruments

(TXN) - Get Report

said two weeks ago that its capex budget probably won't grow from this year's level of $800 million, while

Taiwan Semiconductor

(TSM) - Get Report

reported that spending will likely shrink from its recently reduced budget of $1.65 billion for 2002.

Leading sugar-daddy

Intel

(INTC) - Get Report

kept mum on next year's budget, but it's widely expected to rein in spending. Banc of America's Mark FitzGerald believes its budget could drop to as little as $3 billion.

At that level, spending would have shrunk nearly 60% from Intel's peak budget of $7.3 billion in 2001, and more than a third from this year's $4.7 billion budget. A cut of such magnitude would be a strategic surrender as well as a painful ego check: Intel's usual approach is to funnel loads of money in equipment and research during a downturn, when poorer rivals can't afford it, and emerge the stronger in the eventual recovery.

But some analysts now think the company will have no choice but to hold back spending, given the wan outlook for revenue growth. The cash Intel has poured into equipment buys over the past few years, as reflected in depreciation, consumes an ever-increasing share of its hard-won profits. Depreciation expenses surged to around 17% of revenue and 34% of the cost of goods in the September quarter -- the highest levels in at least 15 years.

At this point, the company has two choices, reckons FitzGerald. It could forge ahead with heavy capex spending, in hopes that processor revenues see a faster-than-expected rebound; then when demand kicks in, it would have widened its lead over rivals. But if the recovery stretches out, expect abounding misery. "The P&L would likely choke on the depreciation expense and the stock is probably $10 or less," FitzGerald writes in a note.

Choice B is for Intel to reel in spending, giving itself some breathing room if a recovery takes longer than expected (which, of course, has already been the case). He thinks that's more likely to be the case, which bodes ill for equipment outfits.

And by the way, Intel is hardly the only chipmaker afflicted with an itchy, burning depreciation rash. Leading names like

Texas Instruments

(TXN) - Get Report

,

STMicroelectronics

(STM) - Get Report

,

Linear Technology

(LLTC)

,

AMD

(AMD) - Get Report

and

Analog Devices

(ADI) - Get Report

have likewise seen depreciation expenses, measured as a percentage of sales, surge well above the levels of past downturns in 1996 or 1998. The odds are they're all taking a long hard look at next year's budgets.

AMAT Could Go Splat

The upshot is, investors betting on a big '03 rebound in equipment are fooling themselves. But leading up to likely cuts in Wall Street's estimates, large-cap names have shot up well above their trough values.

Case in point: bellwether

Applied Materials

(AMAT) - Get Report

now trades at about 3.5 times tangible book value, well above its trough of around two times. That valuation looks to be on the precarious side, given that it's likely to have a tough time meeting the Street's absurdly hopeful forecast for next year.

Analysts currently expect profits

to more than double

, to 37 cents, according to Thomson Financial/First Call. Revenue is slated to grow nearly 11% -- this at a time when the biggest spenders on equipment are likely to shrink their budgets, not expand them. In the meantime, the company yesterday announced a layoff of 11% of its workforce. That's hardly an indicator of an imminent pickup in demand.

Applied's earnings release, scheduled for Nov. 13, may check some of the recent optimism on equipment stocks. In a note, Lehman's Edward White predicts worse-than-expected guidance on revenue and earnings per share for the January quarter: He's betting sales will see a sequential drop of 27%, while earnings will be at the break-even point.

For chip-equipment investors, the last best hope centers on Christmas season sales. Consumers snatching up PCs and cell phones could help support the recent rally in the sector.

"If it's positive there, people will look through the bad news at the bottom," acknowledges FitzGerald. Comments from

Best Buy

(BBY) - Get Report

and the fourth-quarter outlook from

Dell

(DELL) - Get Report

should help investors parse demand.

But so far, economic data don't exactly suggest a barn-burner holiday season, with consumer confidence tanking to a nine-year low and unemployment edging up in October. And if Christmas sales fail to impress, watch out below for equipment stocks.