Outlook for February, January in Review

Eric Linser, CFA | Feb. 4, 2010

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

It was not the kind of start to the New Year for which investors were hoping. In January, a winter chill settled over the markets and we had our first major sell-off since the "reflective" rebound in stocks in March 2009. The major indexes and many asset classes ended the month lower.

Despite the Federal Reserve's confidence in the recovery, promises to keep interest rates low for the time being in order to further encourage recovery and a stellar report on gross domestic product, the markets simply couldn't muster gains. The Dow Jones Industrial Average ended down 4.6% for the month. The S&P 500 lost 4.7% and the Nasdaq declined 6.3%.

To view ETF Trends (etftrends.com) full January exchange traded fund (ETF) and index performance report card on a multitude of asset classes both domestically and internationally, click here.

Going into and during the final week of January, a growing chorus of "media pundits" posited that the extreme downward price action showed the beginning signs of a stock market crash. As expected the"perma-bears" appeared on the financial broadcast channels, with further strong opinions voiced by journalists deluding themselves that they are experienced market traders or economists for what turned out to be a little changed week in an ongoing significant correction after the massive bull run off of the March 2009 low that targeted 10,500 that very few capitalized upon because they were holed up in their bunkers sitting on cash.

The tech-heavy Nasdaq composite declined by 5% in January. Despite the correction in technology stocks in January, we are sticking to our offensive posture heading into February. We remain constructive on the semiconductor group, citing improving visibility and better-than-seasonal growth with continued lean inventories, particularly for names in the PC chain. We remain bullish on IT hardware and would get more aggressive given the recent pull-backs. We remain cautious about the pace of an enterprise IT spending rebound in 2010, but we are picking up pockets of strength in offshore applications outsourcing and web-based software products. As for Internet companies, we are somewhat more cautious, citing good fundamentals but weak Street sentiment that could continue into February.

Over the past few months we have shifted our recommendations to favor secular themes that are less reliant on a V-shaped recovery and more reliant on a continuation of 2009 trends, including the desire for companies to reduce their internal IT infrastructure and increase cost/network efficiency.

Market Outlook

Overall Market Sentiment

The streak of 10 consecutive months of gains in the S&P 500 was rudely snapped in January and was in response to a 4^th quarter 2009 reporting season characterized by an improving tone of business but a pace of recovery more modest than expected. For the first time in months we saw repeated selling into strength, stocks were not getting a lift from generally solid results and the velocity of selling activity picked up discernibly in the second half of January. As illustrated in Exhibit 1, the lower level of investor risk tolerance was reflected in the fact that the "cyclical" sectors (technology and basic materials) that rallied sharply in 2009 materially underperformed the "defensive" sectors (healthcare and consumer staples) in January. Likewise, the presumably "riskier" emerging markets took a significant hit, with markets in China, India and elsewhere down sharply along with US-listed Chinese and Indian stocks.

The fundamental shift in Street sentiment in January was reflected in the technical profile of the stock market. Since about mid-September, the levels of resistance in the S&P 500 steadily inched up, from 1080 to 1100, 1112, and to around 1150. In recent months we have not seen investors aggressively buying the breakout once these levels were breached to the upside and in January the S&P clearly exhibited buyer's exhaustion at the 1150 level. More worrisome from a technical standpoint was the inability of the index to hold the 1100 level and its 50- and 100-day moving averages on the way down beginning in mid-January. The 200-day moving average of 1013 could be the next downside target.

Exhibit 1: January Performance of S&P 500 and the Individual Sectors

Source: Reuters

Technology Sector Analysis

The Nasdaq has now underperformed the S&P 500 in three of the last four months and was down by 5.4%, compared to the 3.7% drop in the S&P 500. Moreover, the S&P 500 Technology sub-sector was one of the worst-performing industry sectors in January, down 8.5%. As illustrated in Exhibit 2 below, we divide the broader technology sector into 16 sub-sectors to help us gauge which technology sub-sectors are outperforming and underperforming. In January, the hardware, semiconductor and semiconductor equipment sectors were each down by 11%-14%, outpaced only by the 15% decline in the Chinese IT and Internet stocks. The consumer-driven handset stocks as well as the more defensive IT services stocks were down the least (down 1%-4%) and the enterprise software sector easily outperformed the hardware, storage and semiconductor names.

Exhibit 2: Best & Worst Tech Sub-Sector Performance in January

Sources: Reuters, Kaufman Bros. Research.

In our judgment, the key catalyst for the technology sector sell-off in the month of January was the weak 4^th quarter 2009 top-line results out of IBM. The Nasdaq peaked the day that IBM reported and has largely trended straight down ever since. We've picked up three broad themes from the results out of IBM, Intel, EMC, Microsoft, VMware, Infosys and SAP in recent weeks and from Oracle and Accenture back in mid-December that could explain the shift in Street sentiment.

First, while the overall tone from these vendors has been incrementally more constructive, the pace of the sequential improvement in 4^th quarter results and (based on company guidance) 1^st quarter 2010 has been more modest than many investors expected, especially for IBM and Accenture. Many vendors are citing growing deal pipelines and expectations for a growth rate acceleration one or two quarters out, but investors are becoming increasingly skeptical and technology stocks are no longer rallying on hopeful comments about the pipeline and an out-quarter growth rate pick-up.

Second, many investors have become more cautious about the pace of enterprise hardware spending in particular. In early January we picked up signals from Hewlett-Packard that enterprise PC spending was still sluggish and in mid-January we picked up similar data points from other manufacturers and vendors. Intel then said on its earnings call that "we're not programming into our guidance any kind of overnight recovery of the corporate market...we think it will start coming back but...we really haven't seen enough so far." Microsoft was clear that "we have not seen a return of enterprise spending growth," and that "enterprise agreement sales cycles have lengthened." On the flip side, Intel, Microsoft, EMC, VMware and others have cited stronger enterprise demand for servers and for virtualization software. This more muted enterprise hardware spending outlook has led many investors to conclude that other components of corporate IT budgets, namely software and IT services, could also be recovering at a sluggish pace.

Third, at least three bellwether technology firms -- notably SAP, EMC and VMware -- admitted to experiencing a 4^th quarter boost from an "IT budget flush." To be clear, this issue is not one of "flushing" a year-end IT budget surplus, but one of a spending catch-up given the deferral of projects originally slated for the 1^st half of 2009 and as clients "starved their IT infrastructures" (as EMC put it) in the 1^st half of last year. The problem for investors of course, is that growth boosted simply by pent-up demand is not sustainable and could lead to a moderation in growth in the 2^nd half of 2010 or possible sooner.

January Performance

We took a more offensive posture heading into January (see our Outlook for January report).  

We were more constructive on semiconductors, data centers and hosting, clean tech and IT services and software. We were somewhat more cautious on Internet, handset and hardware companies. Common themes for our more bullish stance include more reasonable 2010 Street expectations heading into the 4Q09 reporting season, data points suggesting that demand is tracking well and a general observation that higher-beta and high-quality names continue to outperform, even those with relatively high valuations. Looking back, this more bullish tilt heading into January proved to be wrong, although our stock picks/holdings were strong enough to weather the storm reasonably well.

Technology Outlook for February

As usual, the formation of our firm-wide outlook for the technology and telecommunications sectors is rooted in a "bottom-up" view -- looking at the merits and valuations of each company. Despite the factors addressed above, we are sticking to our offensive posture heading into February. We remain constructive on the semiconductor group, citing improving visibility and better-than-seasonal growth with continued lean inventories and reasonable valuations. We view pullbacks as buying opportunities, particularly for names in the PC chain. We hold a defensive posture on server and PC hardware, and would get more aggressive on smart phone manufacturers on pull-backs. We remain cautious on services and enterprise software given a currently anemic pace of enterprise IT spending in 2010. However, we are picking up pockets of strong demand, especially for offshore applications outsourcing and for cheaper web-based software products. We are cautious on Internet companies citing good fundamentals but weak Street sentiment that could continue until earnings season ends in mid/late February.

The majority of our picks for the month of February can be characterized as being high-quality names that, in our judgment, are reasonably correlated to a continued economic recovery. To learn more about the companies we are purchasing for our clients and our approach to the markets, give us a call or email us. Don't let good opportunities go to waste!

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