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The Technology Mini-Crash Of 2014

Technology stocks are back.

Well, not so fast.

There's been a mini-rally in tech since the March/April sell-off in "momentum" stocks. That correction pummeled many small-cap biotech, social media, Internet, solar energy and computer software companies.

Since then, the S&P 500 tech indexes, the Nasdaq 100 and the Russell 2000 have rebounded, albeit in generally low volume. The tech IPO market is showing flashes of life, with Arista Networks (ANET) up 55% since its June 6 debut.

Capital flows into tech-focused exchange-traded funds turned positive in May, according to Bloomberg. And many tech stocks have clawed back above key levels of support.

The first quarter's sudden rotation from high-multiple P/E into lower-multiple P/E stocks, from so-called hyper-growth stocks into value stocks, appears exhausted. But it took a toll.

Many former high fliers are still below their early-year levels. That is true even among many that beat Q1 earnings expectations and revised guidance upward. Analysts say that it's largely because valuation worries linger.

The big question: Have investors regained their appetite for technology, or are they just nibbling at "oversold" stocks

Investors Surf The Economy

The U.S. economy figures significantly into what happens next for tech stocks, says Jonathan Golub, chief U.S. market strategist at RBC Capital Markets.

Golub says that in a low-growth environment, companies in innovative sectors like biotech and social media are attractive. Their earnings expectations are above the S&P 500 average. A hunger among investors for earnings growth drove so-called momentum stocks to new highs this year.

A pickup in U.S. economic growth normally boosts cyclical tech stocks, which are driven by increases in capital spending. As more companies replace old equipment and invest in productivity, semiconductor firms, computer and peripheral makers, and Internet infrastructure providers all stand to gain. Biotech and social media firms are less linked to such increases.

Therefore, Golub says, if the economy beats growth forecasts, non-cyclical growth names become less interesting.

"Because riding the economy becomes an easier play," he said.

That kind of thinking favors semiconductors over social media. It doesn't mean that social media won't do well, Golub says, "but the economy is usually dragging other stuff along.

Tech Group Psychology

Among 197 IBD industry groups, electronics-semiconductor manufacturing, which includes Intel (INTC) and SanDisk (SNDK), ranked No. 8 on Friday, one of only two tech groups listed in the top 20.

Computer-hardware/peripherals, home to Apple (AAPL) and Hewlett-Packard (HPQ), ranked No. 7. The medical-biotech group, which ran at the head of the industry list through most of the first quarter, now ranks No. 38.

Hurt by the rotation into value stocks, the group was also affected by concerns that the government will pressure drugmakers to reduce the prices of some higher-priced products.

The computer software-security group, meanwhile, dropped to No. 62, down from No. 5 in March. Internet-content — everything from Angie's List (ANGI) to Zillow (Z) — ranks No. 90, up from No. 141 a month ago but down from No. 9 in March.

Some in that group have bounced back. Google (GOOGL) and Facebook (FB) breezed past Q1 consensus views on mobile ad growth. But others lag, including eBay (EBAY), Amazon.com (AMZN), Twitter (TWTR), LinkedIn (LNKD) and Groupon (GRPN).

A Tale Of Multiples, Earnings

Shares in cloud software firms Tableau Software (DATA), ServiceNow (NOW) and Workday (WDAY) — all of which reported Q1 earnings that beat estimates — are 40%, 20%, and 30% below the pre-sell-off prices, respectively. Splunk (SPLK), which issued modestly positive guidance, is off 50%.

The rotation into value stocks benefited some large-cap IT stocks. Microsoft (MSFT) and Hewlett-Packard, for example, are ticking off new highs. Funds — perhaps required to maintain tech weightings in their investment portfolios — shopped for stable earnings, analysts say.

Large-cap chipmakers Intel, Micron Technology (MU) and Texas Instruments (TXN) outperformed small caps, says Andrew Burkly, Oppenheimer Asset Management's head of institutional portfolio strategy.

"The (valuation) spread between large caps and small caps was historically high coming into the year. P/E multiples were at 10-year extremes in terms of how small caps were being valued," Burkly said. "In the market behavior we saw during the momentum implosion, some stocks got hit regardless of what earnings were doing. On a sector level, energy did better because people were looking for areas at a below-market multiple. That's where they gravitated.

Burkly added that the Q1 results of tech companies bettered most other industry sectors.

According to Thomson Reuters, 77% of tech companies in the S&P 500 reported Q1 earnings above expectations, second only to the energy sector's 80%. More than 90% of chipmakers reported Q1 profit above views, says Thomson Reuters. Overall, 68% of companies in the S&P 500 reported EPS above views.

The tech sector led other industries in positive Q2 earnings and revenue-guidance revisions, says Thomson Reuters. Texas Instruments and Analog Devices (ADI) were among those that raised margin guidance. Industry association Semiconductor Equipment and Materials International predicts that fab equipment spending will rise 14% to $35.7 billion in 2014 and 11% to $39.5 billion in 2015.

While semiconductor stocks are in favor, Goldman Sachs urged caution in a June 1 report. "Semi cycle is flashing yellow, not red yet," said analyst James Covello. He says that new orders are being driven by automotive and industrial customers rather than consumer or computer products.

"Company anecdotes during earnings point to early signs of inventory build," wrote Covello. "The stocks are no longer undervalued.

RBC's Golub says that investor sentiment has shifted toward less speculative stocks.

"In the bounce-back we've had, some stocks were oversold, but people want to jump back in where there's greater certainty and comfort in earnings.

The Market's TAM Obsession

Talk of a 1999-2000-like tech bubble has cooled.

Frothy, first-day IPOs early this year helped fuel worry over a tech bubble. Valuations of pre-IPO startups surged amid huge funding rounds from venture capital firms.

Analysts say that the inflection point may have come when the IPO of King Digital Entertainment (KING), maker of the mobile game "Candy Crush Saga," fizzled the first day of trading, and money-losing data-storage startup Box shelved its IPO.

Some pre-IPO valuations, such as ride-sharing app maker Uber's $17 billion, remain high. Even so, the number of technology IPOs in 2013 and so far in 2014 is far below that of 1999-2000. China-based Alibaba Group, the year's most anticipated IPO, has yet to take the plunge.

Tech stocks are about 19% of the S&P 500 now versus 35% at the peak of the turn-of-the-century tech bubble. Some observers say that there are other differences.

"There are far fewer growth stocks these days than there were during the tech bubble of the 1990s, when almost any tech company was viewed as a growth stock," said economist Ed Yardeni in a research note.

Heading into 2014, though, some tech analysts saw trouble ahead. "We believe that investors are focusing on expanded TAM (total addressable market) potential, driving price performance higher, especially in our small- to mid-cap names," said analyst Scott Devitt in a Morgan Stanley report on Internet stocks in November.

"In our view, stocks trading at a premium because of a significant TAM opportunity face strong pullbacks even when meeting or guiding at reasonable expectations of growth," the report said.

TAM refers to the revenue opportunity for companies. According to one analyst's estimate in December, for example, the global toy market represented a $48 billion opportunity for 3D printer makers such as Stratasys (SSYS).

Another example: "Is Facebook part of the new tech bubble?" asked RBC Capital analyst Mark Mahaney in an April report. "Heck no, TAMs are at least ten times what they were in 2000.

Amazon's TAM is one of the tech sector's largest, but its stock has dropped on worries over earnings visibility. Investors seem to have less appetite for companies whose valuation is based on long-term TAM opportunities, some observers say.

"We had been worried earlier in the year as investors seemed willing to throw money at concept stocks with large TAMs as these global innovative disruptors (small-cap biotech, 3D printing, social media) were being bid up in almost willy-nilly fashion," said Tobias Levkovich, Citigroup's chief U.S. equity strategist, in a May report. He added that investors had "reversed course."