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Tech Recovery Is Plagued by Potholes

Strong fundamentals are being offset by currency fluctuations, rising rates and no major product cycle.

The always nerve-racking tech stock roller coaster is going to get even wilder in the next few quarters.

Despite unusually strong first-quarter results, and plenty of evidence that the recovery in IT spending is real, technology stocks have struggled since late January. But although valuations have declined significantly as a result, there seems to be no immediate catalyst to spark a rally, and the sector is likely to be buffeted by the dollar's comeback and uncertainty about rising interest rates.

"We had expected a rally now followed by weakness later in the year. But many stocks are breaking 150-day moving averages -- if we don't see strength soon, tech will be back in a bear market," Merrill Lynch's Steve Milunovich wrote earlier this week.

Although the "bear" terminology isn't being used frequently, traders aren't acting like technology companies have been making their numbers, much less besting them. The

Nasdaq Composite

and Goldman Sachs Software Index are each down about 3% year to date, while the Philadelphia Semiconductor Index is down about 13%. By comparison, the

S&P 500

is up about 1%.

Tech-stock weakness has recently accelerated amid the generally positive first-quarter results. One notable exception:

Microsoft

(MSFT) - Get Report

. After a prolonged period of underperformance, the software giant's stock is up about 5% in the last few weeks, an indicator investors are seeking safety.

"We've seen a move away from high-beta stocks in the last six weeks; in telecom equipment, particularly

Nortel

(NT)

and

Nokia

(NOK) - Get Report

, it has become a rush," said John Rutledge, who manages the

(ETCAX)

Evergreen Technology fund.

The ensuing tech correction has deflated forward price-to-earnings ratios by about 10%, meaning that shares are now trading at approximately 19 times 2005 estimates, a historically low level, said Vadim Zlotnikov, chief investment strategist at Sanford C. Bernstein.

The tech sector's forward P/E compares to 16.5 times 2005 estimates for the S&P 500, a relatively modest spread considering Nasdaq 100 earnings are expected to grow 39% in 2004 and 22% in 2005 vs. 11% and 9%, respectively, for the S&P 500, according to Baseline.

"I think tech valuations are good where they sit now," said Tony Ursillo, an analyst with Loomis Sayles & Co., adding that by measures other than P/E -- particularly free and discounted cash flow -- some companies that might seem a little rich are, in fact, good buys. Companies he mentioned with strong cash positions include Microsoft,

Adobe

(ADBE) - Get Report

and

Oracle

(ORCL) - Get Report

.

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However, any valuation improvement amid recent weakness has not spurred renewed interest in semiconductor and equipment stocks, as that industry is apparently

hitting a cyclical peak.

"The real money to be made in deep cyclicals like semis was when things looked bleak about a year ago. It's hard to

make money at this point in the cycle," said Chris Casey, head of portfolio management at Boston Private Bank, an investment management firm with $1.95 billion in assets.

On the software side, meanwhile, analysts say valuations are still so high it isn't likely that June-quarter numbers will support them.

"We'd need a robust upswing of sales to really help software companies in a higher interest rate environment, and with the exception of security and business analytics, I don't see that happening," said Richard Williams, an analyst at Garban Institutional Equities, the equities research arm of London-based Garban-Intercapital.

A big reason skeptics worry about the ability of tech stocks to hit analysts' forward targets is the recent

strength in the dollar after more than two years of pronounced weakness. "Without currency effects, you would have seen a lot more misses in the first quarter," Williams said.

Previously, Zlotnikov estimated the weak dollar contributed 2% to 3% of the 8% corporate sales growth last year and had a "much greater" impact on profit growth. "This tailwind may have already peaked," he added.

There's also the issue of interest rates.

Historically, tech stocks outperform when the

Fed

tightens, said Merrill's Milunovich. "Over the past three Fed tightening cycles, tech has outperformed the S&P 500 by more than 60% one year from the first rate hike and by 25% excluding the tech bubble," he wrote in a note to clients earlier this week.

But we should already have seen a bump in tech prices, based on expectations of higher rates. Tech stocks usually increase an average of 23% during the three months preceding the first rate hike, said Milunovich.

So where's the run-up?

Typically, higher interests rates are accompanied by the emergence of wage pressures, which in turn drive business to buy technology products in the hope of increasing productivity, said Zlotnikov. Wages have fairly stayed flat so far, and more importantly, "in other cycles we have seen applications that drive productivity. But we're not seeing

those applications now," he said.

Recall, businesses rushed to spend money on new or modified software and hardware to cope with the Y2K scare. The launch of Microsoft's Windows 95 operating system also sparked a major upgrade cycle, as did the Internet and the advent of email.

But if there's a big new thing out there today, it's still a well-kept secret.

Call It a Comeback

Nevertheless, the March quarter contained lots of positives, and evidence that IT spending is unlikely to fall off a cliff.

The ratio of negative-to-positive earnings preannouncements (for all public companies) was nearly 50% lower than the historic average, and close to last year's record low, according to Thomson First Call.

Average deal sizes in software -- an indicator of willingness by customers to make a longer-term financial commitment to vendors -- stopped sliding, and in many cases increased. Goldman Sachs technology analyst Rick Sherlund called the shift "a function of improving IT spending conditions and customers' increasing propensity to spend on new revenue-generating projects, not just cost-reduction projects."

Spending by businesses for information technology-related hardware and software rose 16.2% in the first quarter, according to the U.S. Department of Commerce. While slower than the preceding four quarters, which were helped by easy comparisons, that's still quite robust.

"Our basic belief is that the economy is in good shape ... and that while we're not on a huge trajectory upward for IT spending, we're on a good overall upswing," said Chuck Jones, vice president and technology analyst at Stein Roe.

Finally, Microsoft, one of technology's bellwether companies, gave investors something to cheer about. Not only were the company's own fiscal third-quarter numbers good, but also CFO John Connors' upbeat remarks about PC sales to the business sector were something of an

upside surprise.

"We believe Microsoft's surprisingly good results provide more support for our thesis that the overall IT spending environment is improving, with organizations not only increasingly willing to undertake new projects, but also increasingly investing in PCs," said Lehman Brothers analyst Neil Herman.

If companies continue to exceed expectations and provide robust guidance at the end of the second quarter, it will be hard to justify a bearish outlook. But until then, expect continued turbulence.

Hold on Tight
The Nasdaq's up-and-down ride is likely to continue.

Source: Yahoo! Finance

Staff reporter Ronna Abramson contributed to this story.