Looking at Technology: Caution is Warranted

NOTE:  This Market Commentary alert was originally emailed to subscribers at Ritholtz Research & Analytics on Thu 2/8/2007 6:12PM;

This is posted here not as investing advice, but rather as an example of a trading call for potential subscribers. We expect to post future advisories in a similar manner — after the call, but in the correct chronological location on the blog.

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We continue to watch the Nasdaq 100 very closely. While we have found pockets of strength, there are also signs of non participation and actual weakness in the Index. Given the traditional leadership of  Technology, this remains worrisome.

We also that we have been finalizing our research into the sub-prime mortgage markets, and should have that ready by early next week. As we do this, Mortgage Underwriters and Home Builders have been running into trouble. This research is unusually interesting, and we expect you to find the results quite intriguing.

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Some of
the best known and largest tech stocks have done exceedingly well since the
July 2006 market bottoms: Cisco, Oracle, Microsoft, Google, Apple, Akamai, Sun
Micro, EMC, have all put together an impressive streak.

There can
be little doubt that the environment for lots of tech firms have improved
notably since 2002. Balance sheets are much better, new web apps (User
generated content, Web 2.0) have made up for the decreased demand from the enterprise
side. Indeed, much of the excitement in Techland these days is from the newest
tech properties: The YouTubes, MySpaces, and Googles have been where the action
is. Cisco has been enjoying the growth of the Video over the internet business
(See above names), which according to CEO John Chambers, has been booming.
(Apple is a unique creature courtesy of a breakout product).

But not all tech firms are
enjoying a resurgence.
Not participating have been those companies with “issues;” Intel and AMD are
stuck in competitive price wars; other firms have had management problems
(Dell, Yahoo!) or are having problems with recent acquisitions (eBay); still
others can’t seem to get out of their own way (JDSU). Indeed, many tech
companies for one reason or another have been mostly exempt from the Tech
Rally: SAP, Symantec, Sirius/XMSR, Citrix, Flextronics, Qualcomm, etc.

Then there’s Microsoft.

Since
July, its stock is up 50%. We’ve consistently heard three themes given for the
move up from MisterSoftee Bulls:

– The
introduction of Vista

– The
roll out of the new MS Office

– Zune (The iPod killer)

It is hard to describe these product introductions as anything but disappointing. Despite a $500 million dollar advertising budget, Vista arrived with a thud. Only 15% of existing PCs are equipped to handle an upgrade to Vista; Fortunately for the PC makers, Vista’s introduction has led to a surge in PC sales. Indeed, Consumers will primarily get Vista via new PC purchases, and not through (profitable) upgrades. Its looking more and more like the current upgrade cycle won’t be remotely close to that of Windows 95 or XP – missing most of that extra revenue and profit.

And, as far as Enterprise users are concerned, most of the major tech consultants (Gartner, Yankee Group, McKinsey) are advising IT departments wait at least a year before migrating over. The new version of Office has been favorably reviewed, but the huge learning curve may dissuade a rapid migration. As to that mighty iPod slayer, the Zune – it was pretty much DOA. Its program head was unceremoniously shown the door (“he wants to spend more time with his family”). The Apple iPod freight train felt the impact of the Zune like it was a bunny sleeping on train tracks.

Given all this, Microsoft’s shares have begun to soften. We
suspect this is due to reality starting to get recognized by the investing
community that is partial towards tech.  

With
Microsoft softening, the charts are showing signs of technical deterioration.
They have made a lower low; and the uptrend in place since July has been
broken. This is not a particularly healthy technical signal.

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We
continue to wonder why technology has been so inconsistent, eschewing its traditional leadership role in a bull market. Leaving aside Semiconductors – which have not participated in a
meaningful way in the rally, or in nearly any recent time frames –
technology and telecom has seen an uneven, even lumpy distribution of gains.

Given
this mixed performance, we wonder: Has the sudden improvement in Technology Indices
since July 2006 been fundamentally driven, or might something else entirely
been driving share prices?

Let’s
look at some charts for a clue. Prior to this recent leg up, Tech and Telecom
have significantly underperformed other sectors:

Since the 2000 peak, or the
pre-war lows, Tech & Telecom have enormously under-performed:

Buyers of Tech prior to the start
of the War have similarly not been rewarded:

After
under-performing since previous major milestones, the Techs have managed to put together a very nice run. But it is only
since the July 2006 lows that Tech and Telecom have put together a decent
string of out-performance.

As the chart below shows, the ratio of Technology stock to Energy Stocks has finally turned positive. For the first time in years, Tech & Telecom is outperforming Energy.

Why is that significant? Primarily, energy prices having reversed since this past summer. And that’s when Tech/Telecom began outperforming. As the charts above reveal, other time frames have been far less kind to technology.

Ratio of Tech to Energy:

This ratio bottomed precisely in July 2006. Not coincidentally, July 2006 was when Goldman Sachs cut the energy exposure of the GSCI commodity index in half. This subsequently led to a 30% decrease in Oil prices.

Our read is that much of the gains in Tech have come via sector rotation. As fast momentum money pulled out of Energy and Materials, they rotated into these big cap liquid tech names: The Ciscos, Oracles, Microsoft’s, Sun Micros, etc.

As the next chart makes clear, Tech seems to trade inversely to oil lately:

NASDAQ 100 versus US Oil

USO = US
Oil, based on Texas Spot Oil prices

Our suspicions are that the sudden affection for Tech may not be long lived if Energy prices tick back up. As the red line above shows, they are threatening to do just that.

This leads to our conclusion: Investors need to be extremely selective in Technology. There are pockets of large cap strength in Techland, especially big cap Tech – and they may be masking weakness elsewhere in the overall sector.

The NASDAQ 100 now trades at a forward P/E of 33. That means the average Tech stock is somewhat pricey.

Growth rates vary dramatically from company to company, and so to do improvements in revenue. Earnings gains are not uniformly distributed, many tech names have run up in anticipation of sector wide growth – growth that is not very likely to be broad based. Some of the capital appreciation (rising share prices) has come in anticipation of events that may have already taken place, or as with Microsoft, may not come anytime soon, if at all.

Because of this, we urge Investors in the Tech and Telecom sector to be cautious . . .