By Sam Stovall Here's something that hasn't happened in a while. Four of the subindustries in the current Industry Momentum portfolio -- the list of those with top Standard & Poor's Relative Strength rankings -- come from the technology sector. And based on its belief that the technology sector will outperform the S&P Super 1500 index (the combined S&P 500, S&P MidCap 400, and S&P SmallCap 600 indexes) in the coming 12 months, S&P's Sector Strategy Committee voted on Aug. 19 to increase the recommended exposure to the technology sector to "overweight" from "market weight".
S&P's Information Technology sector index is composed of 15 subindustries, including computer hardware and software, semiconductors, and communications equipment. As of Aug. 22, the index represented 17.2% of the S&P 1500 (based on market capitalization) and outperformed the market on a year-to-date basis, rising 28.9% vs. a 13.6% gain in the S&P 1500.
BEWARE: OPTIONS' IMPACT S&P's more positive stance on tech is based on a projected replacement cycle for aging equipment bought in 1999 for Y2K compliance, aided by the U.S. economy's general strengthening and a low interest rate environment conducive to spending on business equipment. Our relative-strength measures indicate that the tech group has bullish momentum compared to most other sectors.
S&P expects that the gradual fundamental recovery experienced by the tech sector in the first half of 2003 is apt to accelerate over the next 12 months. Earnings reports in July and August, 2003, indicate many sector members see business stabilizing at low revenue levels. Some, such as Applied Materials (AMAT), Broadcom (BRCM), and International Rectifier (IRF) have recently experienced upticks in orders. The SARS outbreak slowed electronics sales in Asia this spring, but S&P believes the prior pace of orders was recovered in June.
One other good sign: Merger activity is rising, as evidenced by EMC's (EMC) pending acquisition of Legato Systems, Yahoo!'s (YHOO) deal to buy Overture, and PeopleSoft's (PSFT) acquisition of J.D. Edwards, and Oracle's (ORCL) bid for PeopleSoft. There's a caveat for the sector, however. S&P believes that many technology outfits' earnings quality continues to be eroded by the extensive issuance of stock options to compensate employees.
HOT CHIPS As for specific groups within the sector, we're positive on the chipmakers, as we consider the semiconductor industry to be an early play on a cyclical recovery in technology. By 2005, we expect chip sales to surpass the $204 billion achieved in the boom year of 2000.
S&P expects the software and computer hardware industries to recover in line with the sector, given steady long-term demand trends based on the evolution of the Internet. We believe that the hard-hit communications-equipment industry will likely be a laggard in a tech recovery.
Industry Momentum List Update
For regular readers of the Sector Watch column, here's this week's list of the 11 industries in the S&P Super 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500) as of Aug. 22, 2003.
S&P STARS* Rank
Computer & Electronics Retail/Consumer Discretionary
Best Buy (BBY)
Computer Storage & Peripherals/Info. Tech.
Storage Technology (STK)
Constr., Farm Mach. & Heavy Trucks/Industrials
Consumer Electronics/Consumer Discretionary
Harman International (HAR)
Diversified Metals & Mining/Materials
Phelps Dodge (PD)
Newmont Mining (NEM)
Internet Retail/Info. Tech.
Internet Software & Services/Info. Tech.
Office Electronics/Info. Tech.
Semiconductor Equipment/Info. Tech.
Wireless Telecom Svcs./Telecom Svcs.
* S&P's stock appreciation ranking system for the coming 6- to 12-month period: 5 STARS (buy), 4 STARS (accumulate), 3 STARS (hold), 2 STARS (avoid), 1 STAR (sell). Stovall is chief investment strategist for Standard & Poor's