Last Dance Belongs to Tech

11/25/2010 12:02 am EST

Focus: MARKETS

Michael Murphy

Former Editor, New World Investor

Michael Murphy, editor of New World Investor, expects historically cheap tech stocks to lead the bull market’s stretch run.

This is now the strongest bull market for equities since 1945, according to Birinyi Associates. In the 605 days since the March 9 low, the Standard & Poor’s 500 index is up over 80%. [It’s now 74% higher—Editor.] The next most powerful bull began in 1974 and was up 61% through the same time period.

Technology companies are doing better than the rest of the economy, and technology stocks as a group are cheap. I expect the sector to lead the market up to wherever the final top is in 2011, in part because the only real way out of this mess is to grow your way out, and almost the only real growth comes from tech companies that sell their products worldwide. Tech companies get about 55% of their revenue from overseas, and the falling dollar makes sales abroad that much easier.

The tech-heavy Nasdaq Composite Index gained 18.6% during September and October, its biggest two-month rally since March-April 2009. That clobbered the S&P 500’s 12.8% gain, but it comes after several months of the index lagging behind both the S&P 500 and the Dow Jones Industrial Average.

I have not understood why tech was underperforming, because tech and natural resource stocks are the biggest beneficiaries of accelerating growth in overseas markets, especially in Asia. Now that they are getting some recognition, it also may be good news for the market. A fellow newsletter writer whom I respect, James Stack of InvesTech Research, recently said: “Tech stocks are often one of the top-performing sectors in the first part of a bull market. The market is hitting on almost all cylinders.” [Learn why Stack is so bullish here and here—Editor.]

Because of the long period of underperformance while its fundamentals were accelerating, the tech sector of the S&P 500 is trading at a price/earnings ratio of 13.9 time forward earnings, only slightly higher than the 12.7 times on the entire S&P 500, while growing twice as fast. Tech usually has the highest price/earnings ratio of the ten S&P sectors, but now ranks sixth with a P/E well below the 21.9 times average since 2003.

Tech sector profits grew 39% year-over-year in the September quarter, with sales up almost 21% from last year, the best revenue performance of any sector. During the past 30 days, analysts have raised tech-stock earnings estimates by 1.5%, the largest increase of any sector.

[For specific tech investing ideas, see Charles Carlson’s recent recommendation 6 of Texas Instruments (NYSE: TXN) and a video interview with James Stack in which he favors “forgotten giants” Microsoft (Nasdaq: MSFT) and Intel (Nasdaq: INTC). Jim Lowell of Fidelity Investor recently listed that manager’s specialty fund offerings in communications equipment and information technology among his Four Funds for the Recovery—Editor.]

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