Cash from the sidelines is pouring into technology funds these days as investor fear has abated, sparking a phase of accumulation on Wall Street.
Following three years of devastating losses in which it took more blows than Gerry Cooney in a title fight, the technology sector has bounced back and is now garnering assets at a rapid pace. In fact, the average technology mutual fund is up more than 30% year-to-date, according to Chicago-based fund tracking firm Morningstar. Further proof of a tech revival can be seen in the tech-laden Nasdaq Composite Index, which has risen 56% since hitting multi-year lows on Oct. 9. Most notably, semiconductor and Internet stocks have turned in stellar performances.
Still, that may not be enough to support the bullish case for the tech sector. Investors have heard chatter about second-half recoveries before only to have the rug pulled out from underneath them. That leaves them wondering if they're being led down that path again. So the question remains: Is this rally the real deal? Some investment professionals are finding it tough to swallow.
"I am skeptical about a durable recovery in technology shares," said Keith Keenan, vice president of institutional trading and a partner at New York-based brokerage Wall Street Access. "The current rally has been driven by liquidity and improved sentiment rather than a strong uptick in fundamentals."
Keenan believes that many companies have been able to restructure their balance sheets and reduce interest expenses because the Federal Reserve has kept interest rates down. Currently, the Fed funds target rate rests at 1%, the lowest the lending benchmark has been in 45 years. That landscape has created a lean cost structure for many tech companies, which will enable them to realize strong bottom-line growth on a small uptick in top-line revenue, he said. However, he doesn't think that revenue will grow enough to justify the recent tech stock gains.
"I'm not seeing any evidence of a broad-based recovery in technology," said Mark Schappel, a software analyst at McDonald Investments of Cleveland. "Right now, [tech] stocks are ahead of the fundamentals." Among the mid-tier software companies Schappel covers, many of them are actively pursuing acquisitions, suggesting that conditions may have stabilized. He is projecting a very flat third quarter for software but said that things will pick up in the fourth quarter. Then, and only then, will it be clear if the wheels of recovery are in motion, he said.
That is not to say that things aren't improving. The second-quarter earnings season produced a number of positive results, as a majority of tech companies met or exceeded expectations. Software outfit PeopleSoft, which staved off a hostile takeover from rival Oracle, gave investors something to cheer about with its upside surprise. Chip equipment maker Novellus Systems said revenue came in ahead of estimates and issued a rosier outlook for third-quarter bookings, citing a rebound in the PC industry and parts of the telecommunications space. And Qualcomm said there is no longer a chip inventory surplus in Asia and that supply and demand in the distribution channels "will normalize" by fall.
Microsoft reported better-than-expected revenue for its fiscal fourth quarter and raised estimates for 2004. The software giant's earnings did come in at the lower end of the range, however, falling a penny shy of analysts' expectations. Overall, it was a solid quarter for the company.
Elsewhere, computer services giant IBM posted net income $1.7 billion, or 97 cents a share, matching analysts' consensus estimate. Revenue for its latest quarter rose 10% to $21.6 billion. But that figure is misleading because most of that revenue came from currency gains. And its technology services division was responsible for the revenue spike, recording a 14% gain. Meanwhile, sales at Big Blue's software and hardware divisions fell 2% and 6%, respectively. So while there is cause for optimism, there are really no eye-popping numbers out there.
Bill Seale, principal and director of portfolios at ProFund Advisors, which oversees the $4 billion ProFunds shop, believes that "a recovery is underway" but threw out some red flags that could prevent this rally from being sustainable. For one, he is concerned that the federal tax breaks implemented by the Bush administration will end up being shouldered at the state level. States are already under financial duress, particularly California, which recently borrowed $11 billion to cover its budget deficit, further protracting its fiscal woes.
Since revenue at the state level must equal expenditures, Americans will likely face a tax hike in the current fiscal year. Seale argues that state and local governments must come up with an agreeable solution to this problem in order to sustain an upturn. Another important building block for recovery is a significant increase in information technology spending. Seale said he would like to see two or three more quarters of increased spending before he is completely sold on a recovery.
"The IT spending outlook is weak," Keenan noted. "Overcapacity issues still haunt the technology sector and there are still too many weak players that are surviving due to the low cost of capital. As a result, very few tech companies have pricing power." He sees the Nasdaq 10% to 15% lower by year's end.
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