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Jubak's Journal
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5 stocks for the coming technology rally
The seasonal earnings bounce is likely to be weaker than usual. But I see two winning strategies and 5 stocks in particular that should get a boost if theres a year-end technology rally.
By Jim Jubak
It looks like the battered and bruised technology sector is getting close to a bottom. If thats true, and I think it is, then the sector is setting itself up in almost classic fashion for a strong rally in November and December.
Just one problem, though. With all the uncertainty about technology earnings, what stocks do you buy to make the most (and risk the least) in this rally?
To answer that, youve got to look at trends in the sector that show where revenue is growing and where its not. You also have to look at the structure of this still very dysfunctional stock market.
After Ive done so, Ill give you my five technology picks for trading the coming rally.
3 good signs for tech
First, here are three signs that technology stocks are getting ready to rally:- Tech stocks have stopped falling on bad news. After the market closed on Sept. 29, Micron Technology (MU, news, msgs) reported earnings of 14 cents a share for the quarter that closed Sept. 2. Analysts had been expecting 21 cents a share. The day after that 33% earnings miss, the stock dropped a whole 4 cents a share, or less than 1%. It looks like investors have been about as pessimistic as theyre going to get. And thats usually the sign of a long- or short-term bottom for a sector.
- Wall Street is up to its usual upgrade/downgrade/upgrade games. After pounding away at stocks in the sector for weeks, analysts look like theyre ready to reverse course. Of course, thats because all those downgrades drove down tech stocks to levels that Wall Street now finds attractive. On Oct. 1, J.P. Morgan upgraded semiconductor-equipment leaders Applied Materials (AMAT, news, msgs) and Novellus Systems (NVLS, news, msgs) to overweight from neutral. The stocks, J.P. Morgan said, should outperform the market for the next several quarters. Wasnt too long ago that Wall Street argued wed seen the earnings peak for the chip-equipment makers and it was time to underweight the stocks.
- The technical indicators for the technology-heavy Nasdaq Composite Index ($COMPX) have turned positive. After putting in an Aug. 12 low at 1,752, the index rose to cross its 50-day moving average on Sept. 10 (and then tested that crossover on Sept. 24). Thats a positive sign. Then, on Oct. 1, the index moved above short-term resistance at 1,900. The next major resistance is at 2,055. This is a positive sign. The Nasdaq is building the kind of early momentum that often brings new money off the sidelines and into a rising market.
There's always a 'but'
But, and its a big BUT, tech-sector fundamentals say, yes, investors are likely to see the traditional seasonal bounce in revenue and earnings for the third and fourth quarters, BUT the seasonal bounce is likely to be weaker than usual. And it'll be especially spotty this year, leaving some sub-sectors with almost no seasonal boost.
The best work Ive seen on how the seasonal technology revenue (and therefore earnings) bounce is shaping up is in a Sept. 30 report from Goldman Sachs analyst Andrew Root.
Global semiconductor revenues were up 5.7% in August from July levels. The increase is stronger than the typical seasonal median July-to-August increase of 3.7% over the last 19 years, Root notes.
Thats the good seasonal news.
BUT (if it seems like theres always a BUT with this sector, now youre getting my point) the September data show that revenue gains have slowed and that the third quarter will be up 1%. The increase would be below the seasonal median for second-to-third-quarter growth.
The problem is that while unit sales of some chips, such as the microprocessors sold by Intel (INTC, news, msgs) and Advanced Micro Devices (AMD, news, msgs), are showing signs of a strong recovery -- up 50% from a weak July -- sales of other chips, such as the digital signal processors (DSPs) sold by Texas Instruments (TXN, news, msgs) -- up just 13% in August -- are still weak. The historical average August increase for the DSP sub-sector is almost 21%, Goldman Sachs calculates. Sub-sectors such as DSPs and analog are still working off high inventory levels built up over the summer. Other sectors, such as flash memory and microprocessors, are showing typical seasonal surges in demand, amid signs that customers have worked off much of their excess inventory in September. And still other sub-sectors, such as the microcontrollers sold by Texas Instruments and Microchip Technology (MCHP, news, msgs), are showing seasonal surges in demand and improving prices. Average selling prices in the microcontroller sub-sector climbed 2.4% in August.
Failing to find a pattern
Youll find the same lack of a pattern throughout the technology sector. Whether its wireless phones, flat-screen displays or graphics processors, some parts of each industry are doing seasonally well and others, because demand still lags or because excess capacity is depressing prices, are lagging the median seasonal pickup.
The technology revenue and earnings picture for the seasonally strong third and fourth quarters just isnt uniform enough or strong enough this year to lift all boats. There will be just enough third-quarter earnings misses, even after all the warnings, and disappointing fourth-quarter guidance from tech companies to keep investors on edge.
That wouldnt be such a problem if this stock market werent still distorted by investors reasonable reaction to the excesses of the 1990s and the punishment dished out by the bear market that began in 2000.
We talk about the stock market as if it were one uniform market. But its really a series of interacting markets. In each of these, investors have time horizons for holding stocks, criteria for deciding how much to pay and when to buy, and reasons for deciding its time to sell. Value investors, for example, make up a sub-market thats distinct from the sub-market of momentum investors. And its extremely unlikely those two markets will ever agree on the value of a stock.
The key to a healthy market
Actually, thats a good thing. In fact, its critical to the healthy functioning of the stock market. As my colleague Jon Markman has noted again and again in his Supermodels column, individual stocks regularly get passed from investors in one of these sub-markets to another. A stock that's originally priced by value investors may appreciate until its picked up by growth investors and then finally, at a higher price justified by its relative strength and technical pattern, wind up in the sub-market of momentum investors. In the other direction, momentum stocks regularly get passed to growth investors.
Its a problem for the market when any of these sub-markets is missing. The current market for tech stocks is short on value and growth investors. Value investors, by and large, dont think tech stocks are cheap enough, even now. Growth investors, by and large, dont trust the growth stories of the sector's stocks. Too many of us remember not only what happened to the growth stories of 1999 in 2000-2002, but also how the technology growth stories that seemed so convincing in January turned so sour this year. This leaves most of the heavy lifting in any rally to momentum investors and program traders.
Those groups are certainly strong enough to get the sector rolling and to generate a two- or three-month rally, BUT (theres that word again) unless growth investors in some numbers decide to buy into the rally, it isnt likely to last beyond January or to convincingly break the trend toward lower highs that has ruled the Nasdaq since January.
This leaves investors who want to take advantage of the impending technology rally with two choices.
Two options, 5 stocks
First, you can go with the kind of low-priced, high-momentum stocks that often lead any short-term momentum-driven rally in this sector. (Think back to 2003 for an example: That year, when the Nasdaq climbed 50%, it was led by low-priced and risky issues, not by shares of industry leaders. 2003 was a great year for owning Cisco Systems (CSCO, news, msgs) as the stock climbed 84%. But it was an even better year for owning Nortel Networks (NT, news, msgs), which temporarily climbed off the canvas to soar 163%.)
If youre looking for a stock like that for this rally, Id suggest JDS Uniphase (JDSU, news, msgs), which traded at a closing high of $5.73 in January but now sells for about $3.44, or Harmonic (HLIT, news, msgs), which hit a closing high of $13.15 in February and now trades around $6.79. Both stocks show modest improvement in their relative strength numbers: JDS Uniphase has climbed to a relative strength of 36 over the last three months, from a six-month relative strength of 21. Harmonic shows a three-month relative strength of 25, up from 13. Lets be clear on what youre buying with stocks like these: Its the leverage on any rally that comes with their low price per share.
Your second choice is to go with stocks that are pure plays, or as close as you can find, on the pockets of fundamental growth in the tech sector. For example, Id suggest Microchip Technology because of the strength of revenue growth in its core microcontrollers market. Its 52-week high is $36.50 and the recent price is $28.02. The shares have recently moved above the 50-day moving average. Micron Technology is a relative pure play on memory chips. It trades at $12.34, down from a 52-week high of $18.25. Texas Instruments is strong in microcontrollers (above seasonal growth) but exposed to DSPs (below seasonal growth). But its likely to be a stock of choice for institutional managers looking for a liquid way to play any technology rally. Shares trade near $22.54, down from the 52-week high of $33.98, and relative strength has climbed to 31 over the last three months from a six-month 16.
Id wait a little bit longer to buy any of these stocks for a year-end technology rally. It would be great to get any negative surprises in the third-quarter earnings announcements out of the way. Besides, history suggests that the best time to buy for an end-of-year rally is around Oct. 15, when year-end tax selling has had a chance to set in and maybe produce a new low or two.
Ill be watching and waiting until then.
New developments on past columns
Third-quarter 2004 performance for Jubaks Picks
Its time for the end-of-quarter (and longer) performance numbers on Jubaks Picks. The good news is that unlike the three indexes I use for a benchmark, Jubaks Picks didnt lose money in the third quarter. The bad news? The Picks were up a meager 1.5% for the quarter. In any period, I try to take what the market gives, but this quarter it seemed to take away with one hand what it gave with the other. Land, oil, oil service, copper and gold in the form of The St. Joe Company (JOE, news, msgs), Shell Transport & Trading (SC, news, msgs), Schlumberger (SLB, news, msgs), Southern Peru Copper (PCU, news, msgs) and Newmont Mining (NEM, news, msgs), respectively, all worked. But formerly steady growth stocks such as Engineered Support Systems (EASI, news, msgs) and Rogers (ROG, news, msgs) tumbled on earnings worries or actual bad news. I think the next quarter will bring a solid rally to end the year and Ive positioned the Picks to take advantage of that. But I dont expect the rally to last very far into 2005. This is still a trading-range market, I believe, until it proves otherwise. Heres how I did against the major indexes:
| Jubaks Picks vs. the major averages | | Index | Third quarter 2004 | Trailing 12 months | | Jubak's Picks | 1.5% | 31% | | Nasdaq Composite | -7.4% | 6% | | Standard & Poor's 500 | -2.3% | 12% | | Dow Jones Industrial Average | -3.4% | 9% |
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Im up 13% for 2004 to date. That compares to year-to-date returns of -5% for the Nasdaq Composite, breakeven for the S&P 500 Index ($INX) and -4% for the Dow Jones Industrial Average ($INDU). Here are longer-term performance numbers for three years, five years and since the inception of the portfolio:
| Jubak's Picks vs. the indexes -- the long-run picture | | Index | 3-year return* | 5-year return** | From inception*** | | Jubak's Picks | +46% | +23% | +118% | | Nasdaq Composite | +27% | -31% | +42% | | Standard & Poor's 500 | +7% | -14% | +35% | | Dow Jones Industrial Average | +15% | -2% | +40% |
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*Close on Sept. 28, 2001, through close on Sept. 30, 2004. **Sept. 30, 1999, through Sept. 30, 2004. ***May 7, 1997, through Sept. 30, 2004.
As is my practice, I will update these performance numbers at the end of the next quarter in December.
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: JDS Uniphase and Micron Technology. He does not own short positions in any stock mentioned in this column.
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