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Dare we believe in a chip rally?
As a general undercurrent of optimism surges, so does hope for a highly contagious chip rally that might spread to the broader market. Four experts weigh in.
By Jon D. Markman
An electrifying change has taken hold in the market in the past couple of weeks that goes well beyond the simple sense that stocks are behaving better. For the first time in more than 18 months, shares of the nations major utilities have definitively weakened, while the shares of the nations major technology companies have gathered strength.
The switch in market leadership from companies that are bought for dependable cash flows to companies that represent a speculative bet on the future says a lot about the potential for the strength of the recent rally. It says that investors are finally emerging from their defensive, woe-is-me stance toward equities and are instead staking their money on the potential for better times ahead.
This undercurrent of optimism is most clearly evident in the ratio between the Dow Jones Utility Index ($UTIL), which tracks the nations 15 largest electricity and natural gas distribution companies, and the Philadelphia Semiconductor Sector Index ($SOX.X).
The ratio between the utility and semiconductor indexes -- now trading at 364.89 and 425.23, respectively -- is currently at 0.86. To produce a more definitive signal of a growing taste for risk, the ratio would have to drop below 0.81. To do that, the utility index would need to sink to around 350, while the SOX would need to trade at around 435 -- both of which would be real trend-changing levels.
These kinds of shifts dont occur very often, and they are typically persistent. The last time this change took place, it lasted six months -- from July 2003 to January 2004. Over that span, innovative chip maker Broadcom (BRCM, news, msgs) rose 60%, while chip-equipment maker Teradyne (TER, news, msgs) rose 55%. Before that, the change in the mood for risk aversion persisted much longer -- from August 1998 to March 2000. In that heyday for technology stocks, industry mainstays like Intel (INTC, news, msgs) rose over 500% in value.
A chip rally would be most welcome for the overall market, since success in these stocks tends to lead directly to success for the rest of the companies that trade on the Nasdaq -- and the Nasdaq, in turn, tends to lead the rest of the market. Dare we contemplate the possibility? Lets listen in on four experts opinions.
Bullish ... but with a catch
Putting in a vote for continued strength for semis and the rest of their volatile crew is this columns favorite market timer, Paul Desmond of Lowrys Reports. Longtime readers will recall that Desmond uses proprietary measures of investor buying pressure and selling pressure to size up the strength and potential longevity of important intermediate-term market moves. Back on April 20, which turned out to be the actual bottom of the market so far this year, he said in my column (Why market skeptics see a huge opportunity") that the Dow Jones industrials ($INDU) scary dip below 10,000 that week would be seen in coming months as a great buying opportunity.
Indeed, the Dow has rallied 5% since then, while Intel has jumped 17%.
Related news and commentary on MSN Money
Rather than rest on his chipper laurels, Desmond is now even more bullish -- observing that all the evidence in his database encompassing 70 years of market data suggests that the stage is now set for the final leg of the cyclical bull market that began in October 2002. In a note to clients last week, he said probabilities now favor a rally lasting five months from the April low that will result in a 22% gain in the Dow Jones industrials. That would take the Dow to 12,173 by September -- about 4% higher than its all-time peak of 11,658 in December 1999.
As you might expect, this outrageously sanguine view comes with a catch: Late-stage rallies are not broad-based, as investor appetites increasingly narrow to a select few successful sectors. As the move higher in the major indexes progresses, profit-taking in stocks left in the cold increases -- and investors should cull them out, rather than adding to them in anticipation of later participation. By the end of the move higher, Desmond forecasts, buying pressure should begin to measurably dry up and stocks will plateau. That will be a warning to shift back to defensive positions, he says, though at the time many will be anticipating that it would be just a pause in a larger advance.
The shadow of inflation
Ned Davis, whose quantified views on market timing (and the economy) are equally valued by the institutional community, is also on the recovery bandwagon -- though his catch is more immediate. He believes that the threat of inflation poses the greatest risk to the advance of the Nasdaq, as his studies show that when the year-to-year change in the Producer Price Index is greater than 3.3%, the tech-heavy index suffers disproportionately. At 4.8%, the PPI has exerted a negative effect on the Nasdaq so far this year.
While the Nasdaqs relative strength in recent weeks has triggered a "buy" signal for the Nasdaq in his models, he said in a note to clients on Monday morning, he has yet to see confirmation of the signal from the indexs advance/decline line and relative volume measures, while the rising spread between the Moody Baa bond yield and the 10-year Treasury bond yield is definitively negative for the index. Furthermore, he notes that when a cyclical bull market is in its final third, the Dow Jones industrials tend to outperform the Nasdaq by more than 3.3%.
So while Davis sees the potential for continued Nasdaq strength, he would tend to side with the Dow Jones industrials over the summer if a definitive rally ensues.
Too little fear
Bank of Americas researchers were out with a note on Monday in concurrence with that view, stating that overcapacity and decelerating demand for hardware and software are real problems, and valuations are actually higher in many cases than before the Nasdaqs tear higher in the late 1990s. Moreover, Bank of Americas analysts are worried about the lack of fear among technology investors as the Nasdaq Volatility Index ($VXN.X), which measures volatility for Nasdaq 100 options, hit an all-time low on Friday.
Analysts at the Canadian-based brokerage CIBC, meanwhile, added their own log to the fire on Monday, downgrading the chip sector to market weight from overweight as they see an uneven bottom for the fundamentals of the group through a long, slow summer -- and suggesting that the Street will end up shaving down second- and third-quarter estimates for the group. A full-fledged recovery for the group, they said, is a fourth-quarter event.
If we are to put all of these views into one package, we can see the potential for a decent boost in the Dow Jones industrials over the next three or four months that is not complemented by a somewhat-softer advance in the Nasdaq generally and tech stocks specifically. To take advantage with stocks that are neither mega caps nor small caps, here are 15 companies in the S&P 500 that have the best relative strength in the past three, six and 12 months, are rated 9 or 10 by StockScouter and have market caps between $1 billion and $20 billion. I will track them over the next six months and report back.
| Strong stocks | | Company name | Market cap | SS* | Last price | % Chg YTD | Price/Sales | | Genzyme (GENZ, news, msgs) | 16.1 B | 9 | $64.03 | 9.9 | 6.9 | | J.C. Penney (JCP, news, msgs) | 13.7 B | 10 | $50.93 | 22.4 | 0.7 | | Pulte Homes (PHM, news, msgs) | 9.4 B | 9 | $75.00 | 15.3 | 0.8 | | CSX (CSX, news, msgs) | 9.1 B | 9 | $42.04 | 5.0 | 1.1 | | Fiserv (FISV, news, msgs) | 8.2 B | 9 | $43.05 | 7.3 | 2.2 | | Nordstrom (JWN, news, msgs) | 8.1 B | 9 | $59.70 | 28.2 | 1.2 | | Autodesk (ADSK, news, msgs) | 8.1 B | 10 | $36.65 | -5.5 | 6.6 | | KB Home (KBH, news, msgs) | 8.1 B | 10 | $65.30 | 21.1 | 1.1 | | ProLogis (PLD, news, msgs) | 7.9 B | 9 | $42.14 | -2.6 | 9.0 | | Express Scripts (ESRX, news, msgs) | 6.9 B | 10 | $93.78 | 22.6 | 0.5 | | SAFECO (SAFC, news, msgs) | 6.7 B | 9 | $53.17 | 1.6 | 1.1 | | Health Management (HMA, news, msgs) | 6.1 B | 9 | $25.00 | 9.5 | 1.8 | | Hospira (HSP, news, msgs) | 5.8 B | 10 | $37.04 | 10.0 | 2.2 | | Goodrich (GR, news, msgs) | 4.9 B | 9 | $40.94 | 25.3 | 1.0 | | CMS Energy (CMS, news, msgs) | 2.8 B | 9 | $13.04 | 25.3 | 0.5 |
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*Stock Scouter rating
Fine Print
To learn more about the Dow Jones averages, visit this page. To view the components of the Philadelphia Semiconductor Index, visit this page, and to learn how it works visit this page. ... Back on Feb. 9, I proposed a Diversified Dow 18 that included Dow industrials, transports and utilities. The group is flat since then. The industrials that I picked are exactly flat; the transports are down 4%; and utilities are up 2%.
Jon D. Markman is publisher of StockTactics Advisor, an independent weekly investment newsletter, as well as senior strategist and portfolio manager at Greenbook Investment Management. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at jon.markman@gmail.com; put COMMENT in the subject line. At the time of publication, he held no positions in stocks mentioned in this column.
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