The initial technology rally was led by Internet-related stocks (including eBay and Yahoo), followed closely by semiconductors. Semiconductors and semiconductor-equipment stock performance is generally tied to the perception and, eventually, the reality that semiconductor capacity utilization is increasing, letting chip prices rise. The combination of declining capacity and increased end-product demand has led to a fast recovery in chip prices.
Many analysts expect that semiconductor demand will outstrip supply through 2005. This should result in higher revenue, operating margins, and profitability for most semiconductor companies. It also explains why companies such as Intel and Texas Instruments have seen substantial share-price recovery this year. And it should benefit many related companies, such as leading global wafer-outsourcing companies Taiwan Semiconductor Manufacturing and United Microelectronics. Past concerns about the strength of the recovery have restrained capacity additions. As the economy picks up, foundries will have to start adding capacity to meet demand, because older plants have been shut down. This means semiconductor equipment demand will start rising again--good news for companies such as Applied Materials.
Which leads us to the bad news. Most sell-side analysts on Wall Street are playing the "relative" game. For example, if a technology stock is valued at a price/earnings multiple ratio of 20 times forward 12-month earnings, but the industry peer group sells at 25 times, then the potential target price of the 20-times multiple company may eventually rise to the peer average. Part of this is in anticipation of the recovery in earnings as overall technology demand accelerates with the global economic recovery. From another perspective: Despite low earnings, many semiconductor stocks are beginning to trade at price-to-sales multiples consistent with their prebubble peaks. Technology share prices are anticipating substantial operating leverage in the near future. For their sake, it better happen or tech stocks could trade downward.
Though the economy is on the mend, large government deficits will cause interest rates to rise--and in such an environment, almost all equities go down. This is explained by the fact that future earnings get discounted by some rate to a current value. If the Treasury-bill rate reflects interest-rate moves, all future earnings are worth less when interest rates rise. This doesn't mean some companies won't counter the trend, but it will be company-specific. Because tech stocks usually have higher price-to-earnings multiples, they'll also suffer a compression in their multiples when interest rates are rising, potentially causing even higher volatility in their prices in the near term.
But don't get me wrong. While I remain a long-term bull on technology, it never hurts to take some profits.
William Schaff is chief investment officer at Bay Isle Financial LLC, which manages the InformationWeek 100 Stock Index. Reach him at [email protected]. This article is provided for information purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security. Bay Isle has no affiliation with, nor does it receive compensation from, any of the companies mentioned above. Bay Isle's current client portfolios may own publicly traded securities in one or more of these companies at any given time.