Tech Stock Gains: Rational Exuberance?

For stock investors, there lately has been no better sector than tech. Although many major stock market indexes hit highs for the year on Sept. 15, technology companies have clearly led the way.

So far this year, the tech-heavy Nasdaq composite index is up a whopping 33%. By contrast the broader Standard & Poor's 500-stock index is up 16.5% and the Dow Jones industrial average has advanced 10%.

Technology stocks have nearly healed the damage inflicted during the past 12 months. Since the collapse of Lehman Brothers in mid-September 2008, the information technology sector has now lost a mere 1.9% of its value, according to data provider Capital IQ. The S&P 500 is down 16% and the financial sector is still off 30%.

Tech stocks had some big advantages over the past year, says Michael Sheldon, chief market strategist at RDM Financial Group. Many tech companies have lots of cash—a valuable attribute in a combined recession and credit crisis. Moreover, "the industry hasn't been under the microscope of government regulation," Sheldon says.

Will techs roar into the recovery?Worries about the expanded role of Washington have weighed on other sectors. Health-care stocks have been affected by uncertainty over health-care reform proposals. The financial sector has seen strong government intervention. And utilities have been subject to speculation about the implications of proposed climate change legislation.

The government is now a key player in the economy. But according to enthusiastic tech investors, the main factor driving this sector is optimism about a global economic recovery. "As we come out of this economic slowdown, these [tech] companies are going to be big beneficiaries," says Robert Bacarella, portfolio manager at the Monetta Mutual Funds (MONTX).

Tech companies have slashed costs and inventories, giving hope that a rise in tech spending will be very profitable for these firms. "A lot of these companies are going to see a sharp ramp-up in earnings when the economy turns," says John Wilson, chief technical strategist at Morgan Keegan.

But will tech spending by consumers and businesses revive?

"a wide swath" of good newsIntel (INTC) raised many hopes when it increased its third-quarter sales forecast on Aug. 28. Other big technology names, including Hewlett-Packard (HPQ) and Dell (DELL) have seen signs of a stabilizing—or even recovering—marketplace.

"The news has been good across a wide swath of the sector," says Uri Landesman of ING Investment Management (ING).

Bacarella owns Apple (AAPL) because he believes consumer-focused tech companies will benefit from an uptick in consumer spending and a replenishing of inventories at many stores. Meanwhile, he says, companies will spend money on technology because it helps them run more efficiently, with fewer workers.

Sheldon agrees. "In an environment where companies are cutting workers or are slow to hire new workers, new tech spending can help increase productivity and raise profits," he says.

If you're a shareholder who lived through the bursting of the dot-com bubble earlier this decade, you know the dangers of too much market euphoria. Is there a chance the stock market has become too optimistic about tech?

technical hurdle: pre-Lehman pricesWilson warns that at least some rallying tech stocks look due for a breather. "They're bound to consolidate a little here," he says.

For technical traders like Wilson, it's significant that tech stocks are approaching their share prices of last fall, before the post-Lehman market meltdown. "We're just now approaching the levels where we really started to break down in late 2008," he says. Still, Wilson believes tech stocks could eventually break through those levels on expectations for higher profits.

So are tech stocks still a bargain at these prices? That depends on whether you believe profits—and the economy—will rebound strongly next year.

Based on most measures of valuation—ratios such as price-to-book or price-to-earnings—tech is "in the middle of the pack" compared to other sectors, Sheldon says. His view: "not truly cheap nor truly expensive."

This year earnings in the tech sector are expected to fall 10% from 2008, according to Thomson Reuters (TRI). In 2010 analysts expect tech earnings to rise 24%.

Bacarella believes Wall Street is now too pessimistic. "These analysts historically are always late to the party," he says. But to see further gains, tech investors need the party to continue. If the economic recovery falters, the tech sector—along with the rest of the stock market—could find it hard to live up to the recent enthusiasm.

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