NEW YORK (CNN/Money) - Texas Instruments, a major supplier of chips for cell phones, and Novellus Systems, one of the largest makers of semiconductor equipment, both gave rosy outlooks for the second quarter late on Monday.

And after the closing bell on Tuesday, Intel reported first quarter earnings in line with consensus estimates and said that gross margins for the year would be about 53 percent, two percentage points higher than previous expectations.

That led to renewed optimism about earnings, particularly in the semiconductor sector, and sparked a big rally in tech stocks. (For more about Tuesday's market action, click here.)

Chip and chip equipment stocks typically lead tech recoveries. That's because an improving economy usually means higher levels of capital spending -- that is, layouts on big tech purchases. And increased demand for chips has a trickle down effect on the rest of the tech sector as a roll out of newer and faster semiconductors tends to lead to a pick up in sales for personal computers and other hardware, software and even telecom.

The nagging question now is whether or not this rally is for real. The short answer? Yes.

"Whatever is good for the economy is equally good, if not better for semiconductors. We had a good 18 months to burn off inventory. Everything looks like up from here," says Ken Pearlman, director of research for Firsthand Funds, a mutual fund group that specializes in technology stocks.

The main cause for celebration was comments by Novellus (NVLS: Research, Estimates) chairman and CEO Richard S. Hill in the company's earnings release. "The semiconductor industry has begun to show improvement in capital spending," he said. In addition, Novellus upped its earnings forecast for the second quarter to 6 cents a share. Analysts had been expecting a penny per share loss.

Novellus's booking to shipments ratio (also known as the book to bill ratio) was greater than 1 for the first time since December 2000. That means Novellus received more new orders than it shipped. This ratio is widely viewed as one of the main barometers of the sector's health and has been going up steadily for the entire group during the past few months. (See chart to the right.)

For Texas Instruments (TXN: Research, Estimates), investors were thrilled to hear that the company expects revenue in the second quarter to come in at $2 billion, higher than the consensus estimate of $1.9 billion. Revenue for the company's digital signal processing chips, a crucial component of cell phones, increased nine percent from a year ago and was up seven percent from the fourth quarter.

And demand for analog chips, used by a variety of industrial customers, is increasing as well. TI's analog sales were up 8 percent from the fourth quarter and orders increased by 30 percent.

But while the recovery is moving along, there's just one problem. Semiconductor stocks have already undergone a stunning rally since the market's mid-September lows. The Philadelphia Semiconductor Index, commonly referred to on Wall Street as the SOX, is up 58.4 percent since Sept. 21. That's more than double the Nasdaq's 27.7 percent return during the same time frame.

Have investors already priced a significant recovery into the stocks?

It depends, says Curt Rohrman, manager of the USAA Science and Technology Fund. The key will be profit margins. As the sector improves, if the chip companies aren't as profitable as during the last peak cycle in 1999, then stocks will likely get hit.

But Rohrman is betting on improving profit margins. He says that he can invest up to 25 percent in a particular sector and that he currently has 24 percent of his portfolio invested in semiconductor stocks, including diversified chip companies with big analog business, such as Texas Instruments, Analog Devices (ADI: Research, Estimates) and Linear Technology (LLTC: Research, Estimates).

Alex Vallecillo, senior portfolio manager with National Investment Management Company, the subadvisor for Armada Funds, also owns several chip stocks throughout Armada's family of growth funds. Vallecillo says investors need to buy chip stocks before it is painfully obvious that the sector has rebounded. "If you wait for all the signs that we're in a full fledged recovery you'll miss all the movement in the stocks," he says.

But he concedes that valuations are approaching peak levels, based on sales and book value. Chip equipment companies, for example, tend to trade at about six times book value (assets minus liabilities) at the peak of a cycle, says Vallecillo. Industry leader Applied Materials (AMAT: Research, Estimates) is now trading at 5.8 times book value and Novellus at 4.1 times book.

And semiconductor companies tend to trade at about 8 times trailing sales at a peak. Currently, Intel and Texas Instruments have price/sales ratios of 7.4 times and 7.8 times, respectively.

The key to sustaining these multiples, Vallecillo adds, is whether or not earnings estimates for 2003 rise substantially. If they do, current valuations won't seem so high. "You need to see sales and earnings accelerate to see stocks go materially higher. The good news is we think that's going to happen," he says.

Some analysts have already begun to make adjustments. Following the Novellus report, Shekhar Pramanick, an analyst with Prudential Securities, raised his 2003 earnings estimate for the company from $1.41 a share to $1.62. That's well above the current consensus of just $1.17 a share. And he says there's room for estimates to go even higher.

For this reason, investing in chip stocks is somewhat paradoxical. The stocks usually have high valuations when earnings estimates are on the rise and are dirt-cheap when estimates are falling. "The way you buy these stocks is to buy when they look most expensive and sell when they look cheaper," says Pramanick.

So what's the best way to play a chip rebound? Pearlman says Applied Materials and KLA-Tencor (KLAC: Research, Estimates) are the two top equipment companies. And in addition to Texas Instruments, Analog Devices, and Linear Technology, Pearlman likes other diversified analog companies, such as Maxim Integrated Products (MXIM: Research, Estimates) and National Semiconductor (NSM: Research, Estimates). Rohrman says Intel is a good way to play an eventual upgrade cycle in personal computers.

Still, not all chip stocks are created equal. Chip stocks catering to telecom equipment companies may still have some pain ahead as long as their customers continue to struggle. Rohrman says he'd be wary of chip companies like PMC-Sierra (PMCS: Research, Estimates), Applied Micro Circuits (AMCC: Research, Estimates), Vitesse Semiconductor (VTSS: Research, Estimates) and Transwitch (TXCC: Research, Estimates). All four took part in the broad chip rally on Tuesday but Rohrman says these stocks will probably give up these gains before long.

Overall though, it's finally looking as if chip companies will have more good news to report. That should help send stock prices higher. "This is not the time to be worrying about the sky falling anymore. That was months and months ago," says Pearlman.