Crunch Time: How Tough Is Tech?

By MARK GONGLOFF Technology companies, which have weathered the financial storm better than most others, are under the spotlight as the second-quarter earnings season begins this week. Makers of semiconductor chips, computers and software have blazed a path for the broader market this year as investors bet that they would be among the first beneficiaries of any economic recovery. While the Dow Jones Industrial Average remains down 5.7% for the year, the technology-heavy Nasdaq Composite Index has jumped 14%. When it comes to earnings, Wall Street analysts may be more optimistic about technology than about any other industry, though that may seem faint praise. Earnings for companies in Standard & Poor's 500-stock index are estimated to be down 36% on average from the second quarter of 2008, continuing a record profit slump. Investors will watch second-quarter earnings generally with some anxiety. A three-month rally in stocks stalled recently as hopes for a quick and robust economic recovery have been frustrated by spotty data, including Thursday's uglier-than-expected jobs report. The news sent the Dow down 1.9% for the week, capping three straight weeks of declines. Even the Nasdaq declined 2.3%. A weaker-than-expected earnings season would remove one of the underpinnings of the fragile market. Strong earnings would restore confidence that a recovery is afoot, at least for profits. Analysts hope tech will offer that justification, particularly after the sector's recent performance. They have raised profit forecasts for tech, while lowering expectations for most other industries. Tech earnings are expected to be down 24%, but that is an improvement over the 26% decline analysts expected when the quarter began. "My confidence in tech earnings power is a lot higher than my confidence in the earnings power of many industrial companies," says Vitaliy Katsenelson, head of research at Investment Management Associates. He sees a reversal of the last stock market recovery, when industrial stocks surged and tech stocks, recovering from their bubble, struggled. "Industrial stocks today are where tech stocks were in 2001." Analysts have also raised estimates for the telecommunications sector, which has acted like tech, and for consumer-discretionary stocks, but that is only because the bankruptcy filing of General Motors Corp. removed the troubled auto maker and its sure-to-be-dismal results from the index. Taking a longer view, the story is the same: Earnings expectations for the full year have improved for tech, telecom and consumer discretionary but worsened for the rest. The divergence between technology and much of the rest of the market is important, because companies such as Intel Corp. and Cisco Systems Inc. are considered good barometers of the business cycle. They often get orders early in an economic recovery, as companies try to anticipate an upswing in demand. And tech has been led by what is typically the most sensitive to demand: semiconductors. The Philadelphia Semiconductor Index, composed of key names such as Intel and Advanced Micro Devices Inc., is up 24.3% this year. "That's good news, because semis are at the front end of the manufacturing process for tech," says Jason DeSena Trennert, chief investment strategist at Strategas Research Partners. "That generally should be a leading indicator for the rest of sector, and the economy." In a rare meeting of the minds, both bulls and bears are favoring technology stocks. Relative optimists like J.P. Morgan strategists call it their favorite sector, while relative pessimists such as David Rosenberg, chief economist and strategist at Toronto wealth-management firm Gluskin Sheff, recently wrote that he "can't really quibble" with the fundamentals of tech's success. Universal love for a sector is often a "sell" signal, contrarians are happy to remind investors. They argue that the market has already digested this good news, suggesting there may be little upside left, particularly if the economic recovery is less than robust. Others say there are several justifications for buying tech, even in a downbeat economy. While a jobs recovery would threaten the profits of a range of industries, from retailers to home builders and financials, it might actually bolster tech companies. "In a weak economy, the last thing businesses want to do is hire people," says Sung Won Sohn, economist at California State University-Channel Islands. "Instead, they choose to raise productivity by employing tech." The bull case for tech is based mainly on business demand here and abroad, juiced by government infrastructure spending. Any extra consumer demand, expected to be weak in the U.S., will just be gravy. A relapse in credit markets, meanwhile, would have less impact on tech companies, which typically generate lots of cash and rely less on debt than do financial and other industries. That is one reason the Nasdaq outperformed the broader market during the Lehman Brothers meltdown last fall. Another story driving tech's outperformance was the idea that emerging-market demand could withstand a collapse in developed economies. The so-called decoupling theory was debunked, but there is still a widespread belief that China, India and other fast-growing economies will need the high-tech software, processing chips and networking equipment U.S. tech companies provide. Those products need replacement a lot more quickly than, say, a Caterpillar earth-mover, guaranteeing more future sales. Write to Mark Gongloff at mark.gongloff@wsj.com