Rising from the Tech Wreck

Is the stock rebound for real--or a sucker's rally?

Give tech investors credit for one thing: They don't give up. Though tech sector executives continue to say they see little sign that demand will pick up before the second half of next year, tech investors have staged themselves quite a party since early October. The combination of improving macroeconomic numbers and surprisingly strong earnings reports from the likes of IBM Corp. (IBM ) and Hewlett-Packard Corp. (HPQ ) was enough to push the NASDAQ index to a six-month high of 1,481.90 by Nov. 25. Although profit-taking brought the index down slightly the next day, it was still up 30% from its six-year low on Oct. 9. For the same period, the Standard & Poor's 500-stock index gained just 17.6%.

Moreover, the rally has lifted the tech sector across the board. Even a sad sack like Net software company Commerce One Inc. (CMRC ), where quarterly revenues have dropped 86% over the past two years, saw its stock jump 80%, to $5.40, in the past month. "Investors are still obsessed with tech," says Donald Luskin, chief investment officer for Trend Macrolytics, a Menlo Park (Calif.) research and investment firm. "They can't let go of it."

Does the runup signal an end to the tech sector's long slump--or is it a sucker's rally waiting to lure another round of victims? While it looks like investors may have gotten ahead of the fundamentals for the moment, there's more to this rally than a head fake. Investors have picked up that the slide in revenues and earnings has stabilized and the risk of downside surprises is waning.

The biggest factor fueling the rise is the sense tech is finally bouncing up from the bottom; there are even signs that the telecom sector may be coming out of its slump (page 86). After five quarters of sickeningly sharp declines, business spending on tech appears to be turning. According to the Commerce Dept., businesses spent $406.9 billion on tech in the third quarter, the third straight quarter that spending increased. More important, that was a 4.3% gain over last year's third quarter--the first time in almost two years that spending grew over the same quarter a year earlier.

Even more promising, spending forecasts show growth slowly returning next year. Despite the yearend strength, worldwide tech spending overall will still drop 2.3%, to $874 billion, this year, according to market researcher IDC. But next year, IDC forecasts spending will increase 5.7%. Sure, that's still less than half the growth experienced in the late 1990s, but it does portend a moderately healthy year more in line with traditional growth rates of roughly 10% annually. "No one is saying we're going to see a blowout year for technology," says Kevin White, an IDC economist. "But we're starting to see, slowly, some signs of improved growth."

Such glimmers of hope sparked the tech rally. Initially, the surge was driven by positive news from bellwether companies like IBM, which was enough to send money managers diving back in, lest they miss a recovery. But other factors have driven the market forward too. Veteran traders also bought up shares in anticipation of a seasonal rally that is typically driven by corporate managers making end-of-year orders to spend their remaining budgets. Turbocharging the rally were hedge funds and other short-sellers frantically covering their positions. As of Oct. 15, traders were shorting 4.1 billion shares of NASDAQ stocks--twice the level of 1999.

Is the rally sustainable? Until stronger demand does materialize, many analysts believe it's close to running its course. Despite two years of corrections, tech stocks are still overvalued compared with historical standards. The forward price-earnings ratio of Merrill Lynch & Co.'s Tech 100 is currently 33.09. While well off the high of 70 hit in March, 2000, that's nearly double the average of p-e's before the tech boom started in 1996. "I think the stocks have gotten out ahead of themselves," says Steven Milunovich, tech strategist at Merrill Lynch. "Ultimately, we could go back and test recent lows."

It doesn't help matters that tech execs continue to be circumspect about their prospects. Part of that, of course, is human nature: Having been brutally punished for being too optimistic at the start of the downturn, few chief financial officers or CEOs see any upside in predicting a turnaround until they are 110% certain it has arrived.

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By Jim Kerstetter in San Mateo, Calif., and Dean Foust in Atlanta, with Cliff Edwards in San Mateo

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