Technology valuations now suggest a modestly favorable risk-reward scenario. The sector remains around 15% above the historical trough levels on a variety of metrics, which is the downside risk but well below past averages on a price-to-sales and price-to-cash flow basis. However, near-term weakness and overly aggressive expectations for 2003 argue for selectivity and gradual additions.
Signs of IT recovery remain muted, with relatively robust demand from financial, health care, and consumer-oriented vertical markets offset by weakness in telecom services, high technology, and manufacturing. This is consistent with the areas of strongest profit growth. There is little evidence that large-scale purchases are coming back-indicating continuing caution and economic uncertainty.
Our survey of corporate IT resellers suggests little change in PC/storage demand but some increased optimism that software demand, especially security and wireless, is rebounding modestly. While we do not see broad evidence of new projects or large infrastructure deployment, the relatively low valuation of software companies argues for a well-diversified overweight position.
Earnings disappointments and subsequent underperformance by the semiconductor industry were driven by company-specific issues related to weak PC sales and high wireless inventory and do not alter our favorable view of the semiconductor cycle. However,
valuations remain too high. We are narrowing our underweight exposure and do not recommend a shift to an overweight position unless semiconductors underperform by an additional 15%.
The valuation gap between semiconductor components and capital equipment was eliminated during the past few months and we no longer favor equipment vendors. In the capital equipment market, back-end test has the greatest pent-up demand and provides a potential trading opportunity. The valuation gap between communication semiconductors and OEM vendors remains unjustifiably high and we prefer OEMs.
Conversely, the valuation gap between computer OEMs and related semiconductors is now at the historical average levels. However, selectivity is warranted given the secular problems faced by PC-related semiconductors.