Outlook for March, February in Review

Eric Linser, CFA | March 3, 2010

(an article on the US stock market and technology shares)

February Marks Markets' Best Month Since November

The Dow Jones Industrial Average ended up 2.6% for February, the Nasdaq added 4.2% for the month and the S&P 500 gained 2.9%. The S&P 500 gain for February put a dent in its 3.7% January decline. Eight of the ten sectors were up for the month, with Consumer Discretionary leading the group posting a 5.3% gain followed by Industrials increasing 4.2%. Both Telecommunications and Utilities were down with returns of -1.3% and -1.9%, respectively. Health Care was basically flat for the month at +0.01%. Year-to-date, the S&P 500 index is down 0.95%, with five sectors up and five down.

Outside the US, global markets started February positive but lost steam as currency and debt issues grew, adding to political uncertainty. Concern over Greece (-8.3% for the month) was extended to Spain (-7.6%). Emerging markets were up 0.4% in February, with Turkey down 12.5% (on an army coup plot), while Mexico increased 4.9%. Developed markets were up 1.3% for the month due to a strong US performance; excluding (ex) the US, developed markets were down 0.3%.

February Index & ETF Report

February was, simply put, up and down for exchange traded funds (ETFs) and the broader markets. To view ETF Trends (etftrends.com) February ETF and index performance report card on a multitude of asset classes both domestically and internationally, click here.

Worries Still Abound

Stocks finished February range-bound as most equity markets remained choppy to finish the week (Feb. 22-26). Adjusted fourth quarter GDP figures show that the economy grew 5.9% (up from 5.7%), but it wasn’t enough to power the markets into positive territory for the week, but many stocks were well up for the month. Stock performance had looked uncertain at best early in the month after a downturn in late January. This came after continued weakness from the PIGS run amuck in the eurozone temple and blasé consumer confidence and sentiment, which we discuss in our Imperfect Pictures of Improvement article.

Some clear signs of struggle still exist in the US economy. Consumer confidence is at lows not seen since last April, retailers are concerned about the impact that joblessness could continue to have on their businesses and both pending and new home sales are still declining. Economists also cautioned that those stellar GDP numbers are not expected to carry on through this year.

This past week, Fed Chairman Ben Bernanke reiterated his stance that interest rates would not rise until the economic recovery was on firmer footing. President Obama renewed his pledge to get healthcare reform through Congress. To accomplish his goal, a summit of senior Democrats and Republicans was held to hash out their differences and find common ground. By most accounts, the meeting was generally a success despite the lack of a deal, if only because it got both sides to have a civil dialogue.

Market Outlook

Overall Market Sentiment

After the relatively unbroken equity market recovery was rudely snapped in January, stocks looked poised to finally enter the long-awaited correction. On a technical level we were not seeing investors aggressively buying the breakout once the major S&P 500 resistance levels were breached to the upside and even as February came to a close the S&P 500 failed to take out its 50-day moving average on six consecutive days. I have spoke of the Dow's struggles with the 50 day moving average at 10,400 (today, March 3rd the Dow closed at 10,397, down 9 points). When I review the other major market indices they have all recently cleared above their 50 day moving average. The Dow will most likely cross above this level shortly. Even though I'm not a technical analyst, this would seem to be a short term bullish indicator. Although it seems that the degree of buy-side conviction has weakened somewhat compared to the levels seen in the 2^nd half of 2009, institutional funds do not appear ready to trim long positions just yet and we'd characterize Street sentiment as "modestly bullish" heading into March. We will get February's jobs data this Friday (March 5th). If the news is neutral to positive then it's quite likely that we could soon rally up towards the old highs about 3% north of here.

As illustrated below, the higher level of investor risk tolerance in February was reflected in the fact that the "cyclical" sectors (technology, consumer discretionary, industrials and materials) that led the 2009 recovery once again materially outperformed the "defensive" sectors (utilities, telecom services, healthcare and consumer staples). This rotation, however, didn't trickle down to a rally in the presumably "riskier" emerging markets-based technology stocks, as China-based technology firms generally underperformed (Baidu was the major exception given the Google-China issue) given actions by the Chinese government to slow down what many believe is an over-heated economy.

February Performance of S&P 500 and the Individual Sectors

Source: Reuters

Technology Outlook for March

We are sticking to our offensive posture toward the technology sector heading into March. In our judgment, an average 2010 P/E multiple of 15x-16x for the bellwether technology stocks remains attractive given the solid tone of business and earnings growth outlook. By segment, we remain constructive on the semiconductor group, citing improving visibility and lean inventories, particularly for names in the PC chain. For hardware, we expect continued strength in consumer PC and smart phone demand and remain bullish on the industry leaders. In IT services and enterprise software, we are picking up signs of sustainable strength in offshore applications outsourcing and web-based software products in particular. The outlook for Internet-related software is mixed, citing weakening sentiment toward the Internet travel-related names but a more favorable outlook toward retail names such as Amazon and eBay as well as Google.

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Technology Sector in Review

Within the technology sector, we stuck to our relatively offensive posture heading into February. Looking back, this offensive tilt proved to be right. The strength in our Focus List names is relatively uniform in March.

We stuck to our conviction heading into February even though the technology sector had underperformed the S&P 500 in three of the previous four months. The S&P 500 Technology sub-sector was down a full 8% in January following weak top-line results out of IBM in particular, and based on fears that the 2010 IT spending recovery trajectory may prove to be muted and that the 4^th quarter 2009 growth rate recovery was based in part on a one-time (year-end) budget flush. Sentiment recovered sharply in February, with the S&P 500 Technology index up 6% and the widely-followed Philadelphia Semiconductor index (SOX) up 7%.

In order to measure the performance of the individual technology segments, we divide the broader technology sector into 16 sub-sectors as illustrated below. In February, the network equipment, cable and satellite, India-based software services and semiconductor segments outperformed while the clean tech, hosting, telecom and US commercial IT services segments underperformed. The best-performing individual large- or mid-cap technology stocks in February were JDS Uniphase, Baidu, Ctrip and Riverbed (each up over 20%) while the worst-performing technology stocks were Palm, American Superconductor and Brocade (each down over 15%).

Best & Worst Tech Sub-Sector Performance in February

Sources: Reuters, Kaufman Bros. Research

Technology Sector Fundamental Analysis

Sentiment toward the technology sector seemed to improve throughout February, boosted in part by generally positive feedback from a few technology-focused investor conferences held in mid to late February. Positive results out of Cisco and Hewlett-Packard (HP) in particular offered support to the bullish sector call and the 4^th quarter results and guidance from a broad swath of technology companies lifted sentiment. Our indications point to a continued sequential improvement in IT spending but cost cutting and efficiency improvements still appear to dominate corporate agendas in 2010. This message anchors our Focus List picks in segments of the technology sector that are most likely to be winners in 2010. By segment, the key events in February included:

• A bullish tone from Cisco as well as better-than-expected 2010 capital expenditure guidance from AT&T and other carriers were the key drivers behind a sharp rally in the network equipment space.
• The consumer electronics sector shrugged-off the weak revenue guidance from Palm as both Apple and Research in Motion rallied after the Palm disappointment.
• The semiconductor sector rallied smartly throughout February, but weakened last week based, in part, on cautious commentary from the head of Samsung's semiconductor division, who expressed caution about end-user demand in the 2^nd half of the year and the current inventory build-up.
• Data points from the hardware space were mixed. While HP reported generally solid January quarter results on the back of strong consumer PC and enterprise server sales, Dell shares stumbled given weak margins and fears of price discounting, and the shares of storage and networking vendor Brocade was down 15% in February on weak Ethernet sales and sluggish results from its government vertical.
• The enterprise software and IT services sectors, traditionally considered to be lagging recovery sectors, underperformed again on the back of a major management shake-up at SAP as well as uninspiring results out of the services segments of both HP and IBM. For IT services and software, we have turned incrementally more bearish on the prospect of a near-term demand recovery in the IT consulting and systems integration space. We’ll know more when industry bellwether Accenture reports their earnings later in the month but we aren’t optimistic that their business has yet turned.
• Vendors in the SaaS segment, including salesforce.com last week, posted strong 4Q09 bookings and set better-than-expected guidance that generally offset weaker-than-expected margins given planned increases in sales and other internal investments.
  

Looking into March, the trajectory of the technology sector recovery will be shaped by a number of key factors. On the earnings front, the February quarter results and the updated guidance out of Oracle and Accenture in late March are key events. On the macro front, concerns are likely to be centered on the potential for a muted IT spending recovery in Europe given the economic pressures and the impact of a depreciating British pound and euro on the technology bellwethers with large European exposures. In a call with investors last week, the CFO of Infosys indicated that "Europe was a mess" and that most of the deals in its pipeline were from US-based clients, and Europe was by far the slowest-growing major region for HP.

The Street will also be looking for color on how much of the 4^th quarter growth rate recovery was driven by a temporary IT budget flush or spending catch-up given the deferral of projects originally slated for 1^st half of 2009 and as clients “starved their IT infrastructures” (as EMC put it) in 1^st half of 2009. The debate continued last week as the CEO of SAS Institute said that the 4^th quarter 2009 sales jump across the software sector was a function of "companies had money left over in the budgets at the end of 2009 and they spent it and now they have to go back to zero and start hoarding it again." The CFO of Cisco countered and said that the recovery is sustainable and is "not just a budget flush."

Technology Sector Valuation Analysis

The technology sub-sector of the S&P 500 index trades at a P/E multiple of approximately 15x estimated 2010 EPS estimates, a valuation multiple just modestly higher than the overall S&P 500 index P/E multiple of approximately 14x. As indicated in Exhibit 4 below, this S&P 500 technology sector multiple is consistent with the median 2010 P/E multiple of 15x for a group of 20 large-cap bellwether names across the technology space. Despite that material 50% rally in the technology sector in 2009, we believe that a 2010 P/E multiple of just 15x-16x remains attractive given the solid tone of business and earnings growth across the technology sector, coupled with very clean balance sheets and the prospect of additional acquisition activity and consolidation throughout 2010.

Tech Sector Large-Cap P/E Multiples

Sources: Thomson First Call, Kaufman Bros estimates

Conclusions

As usual, the formation of our firm-wide outlook for the technology and telecommunications sectors is rooted in a bottoms-up view and in our independent research and analysis, not a lethargic committee-based and center-managed approach. We supplement our own qualitative analysis with quantitative fundamental and valuation analysis and company disclosures cited above.

In conclusion, we are sticking to our offensive posture heading into March. In our judgment, a 2010 P/E multiple of 15x-16x for the bellwether technology stocks remains attractive given the solid tone of business and earnings growth outlook. The majority of our technology picks for the month of March can be characterized as being high-quality names that, in our judgment, are in sectors that are showing continued signs of strength and that are reasonably correlated to a continued economic recovery.

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