Tech stocks should lead the rebound

Michael Sivy, Money Magazine editor at large

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(Money Magazine) -- If you think the economy is going to bounce back from the current slowdown before next spring, as I do, then the natural question is which stocks will lead the market recovery.

There's a strong argument that big growth stocks - and particularly the shares of technology companies - will figure prominently among the next crop of market leaders.

In fact, tech stocks have been outperforming the rest of the market for some time. They may have been getting hammered for the past few weeks. But over the past six months, they've outpaced the S&P 500 by about eight percentage points.

And the fact is, many tech stocks are still relatively cheap. They greatly underperformed the market during the tech wreck from 2000 to 2002. And despite a bit of a comeback in 2003, their price/earnings ratios remained low for such fast-growing companies - even before the most recent selloff.

The argument for the group isn't just statistical. It's true that the P/Es of big growth stocks are at least 15 percent below their historical averages, while value stocks are above their norms.

But what's more important is that tech, in particular, isn't directly exposed to many of today's biggest problems.

Unlike financial services, tech stocks aren't especially affected by falling home prices and defaults on mortgage-backed investments.

In addition, many tech companies carry little debt, so they aren't threatened by tighter credit conditions.

And in contrast to many industrial and transportation companies, tech isn't particularly vulnerable to soaring oil prices - in some cases it actually benefits. The quest to make chips more energy-efficient, as opposed to simply faster, is a big driver of growth in the semiconductor industry. Software firms, meanwhile, are labor-intensive, not energy-intensive. The power they need to tap is brainpower.

Technology companies are also better positioned than many mature businesses to maintain earnings growth if high oil prices start pushing up inflation. Technological innovators typically have more freedom to set prices than do makers of most consumer goods (who can say how much an iPhone should cost?). And because high-tech production typically gets cheaper over time, companies can absorb inflation simply by cutting their product prices more slowly than their manufacturing costs decline.

None of these advantages would matter if the industry's fundamentals were deteriorating. But prospects for many tech companies were visibly improving before the latest economic troubles hit.

After years of hoarding cash, businesses were again making capital investments.

And consumers have been spending on gadgetry even if they're cutting back in other areas such as home improvement.

Tech stocks remain volatile and would probably be hurt disproportionately if the economy deteriorated further. So it makes most sense to add such stocks little by little to your portfolio - and it's crucial to diversify as much as you can.

The easiest way to do that is by putting money into exchange-traded funds that focus specifically on tech stocks.

Two prime examples are the Technology Select SPDR (XLK (Charts), which I own, and iShares Dow Jones U.S. Technology (IYW (Charts).

In addition, two of the technology stocks in the Sivy 70 look like particularly good opportunities.

Intel, the world's leading producer of microprocessors, has enjoyed a turnaround this year. Earnings for the third quarter were up 43%, beating analysts' estimates.

The chief reason has been better than expected growth in personal-computer sales, which have risen about two percentage points faster than forecasters anticipated. Much of this growth is coming from overseas.

Two other factors are contributing to Intel's superior performance. The company has slashed costs, reducing the number of employees by more than 8% this year. That could save $2 billion in 2007 and another $1 billion in 2008.

Intel (Charts, Fortune 500) has also been making gains in its perpetual, fiercely competitive struggle with No. 2 producer Advanced Micro Devices, which is now losing money. As AMD (Charts, Fortune 500) struggles, Intel should cash in big for several years.

Corning, which I added to the Sivy 70 in September, continues to offer high potential growth in its three major businesses.

Liquid crystal display panels, used for computers and large-screen televisions, have been the fastest grower over the past few years. And the outlook remains positive, with sales gains projected at 30 percent a year and costs slowly coming down.

Optical fiber, the product that made Corning (Charts, Fortune 500) such a hot stock during the late 1990s, went through several bad years because telephone and cable-TV companies seriously overbuilt. But as that excess is used up, demand is rebounding, helped by new products such as bendable, high-capacity cable.

Corning's third business, high-tech emissions controls, especially for truck engines, is small but could potentially be quite profitable as an environmental play.

After reporting great third-quarter earnings, Corning has been fairly cautious in its earnings forecast. But last week, the company raised its projections for the current quarter. And both stocks are projected to grow at an annual average of 15 percent or more over the next five years.

So proceed slowly and carefully with your buying. But don't forget that the best profits come from scooping up quality stocks when they're depressed, and then being patient enough to wait for the long-term payoff.