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Wednesday, February 20, 2008

Trying to be constructive (not my strength!)

Tech valuations have come in pretty dramatically over the last several months with the semiconductor index retreating from a 52 week high of 550 in mid July to a low of 334 in the last week or so. The quarterly earnings scorecard has been somewhat icy with notable signs of slippage in terms of business momentum. The post-holiday season has been weak at the retail level. The financial vertical is under an enormous amount of pressure – their bottom lines have dropped and the body count continues.

Money has been pouring into commodities due to inflationary concerns over the last several months as (not because) tech has unwound. Who can blame people for being afraid of inflation? The Fed just dropped rates at an unprecedented pace and your parting gift from the Bush Administration is a tax rebate. Our fiscal spending shows no signs of abatement despite the changing tides. In fact, they seem to be trying to figure out how to throw yet more money at the housing valuation problem.

The last time the Fed lowered rates this quickly it was due to Y2K concerns. This caused a bubble in tech spending as enterprises and their consulting masses rushed to make sure their systems were compliant via upgrades to IT hardware and software. These hardware and software companies, flush with cash, in turn used their coffers to fund ill-fated dot coms, in effect becoming venture capitalists to start-ups with a url and a dream.

It took a few months for the suppliers to hit the same wall as their dot companions. The financing problems started to creep up at Cisco – they started to increase their provisioning for bad loans. The receivables were watched closely by analysts. It was 6 months before the real problems emerged but it took a couple of years to burn off the excess capacity in the system and for growth to resume.

We could get the same long hangover in the industrial economy that we had in the dot com aftermath.

Does it really make sense that commodities would explode in value heading into a recession? During the S&L crisis in the late 80s, the Fed also eased considerably in an effort to stabilize the system as the many layers of the problem were revealed. The CRB spiked for a few months afterward after the S&L bailout began in February. It peaked out in mid 1988 and began a 4 year decline that bottomed out 35% below that peak.

Sadly, I don't have historical data for the SOX to do any kind of valid historical study of how the semiconductors performed in 1988 as the index only goes back to 1994ish. There is a historical inverse correlation between semiconductors and commodities. When the dotconomy took off, cyclicals became a dirty word in day trader lingo – they were cast away and forgotten. This looks like the tail end of the inverse condition to me. People are throwing away tech and chasing the last gasp of commodities.

Some things could go right for tech. Unlimited voice plans in wireless is the beginning of a lower pricing structure which should drive units. Microsoft will ship Vista Service Pack 1 in the near future and maybe the decrepit desktop installed base will get a boost if it's up to corporate snuff. Recessions tend to drive people to the couch instead of the mall. Could we see increased spending vigor in digital TV and internet video? Could someone besides Apple figure out how to monetize it?

Inventories aren't outrageously high. Guidance was understandably cautious from most of the larger OEMs. January was pretty punk. We could start to see some improvement in motherboard builds off the January base as the quarter moves on.

Reasons to sell tech stocks are abundantly clear. Valuations tell me I need to be looking for reasons to buy.

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