NEW YORK (CNN/Money) – Conventional wisdom goes that chip stocks will lead a recovery in the technology sector. After all, chips are the building blocks for nearly every high tech device.

So the upgrade of the sector by two prominent Wall Street firms during the past two days should be great news. But investors didn't seem to be that excited.

On Wednesday, Morgan Stanley's Mark Edelstone upgraded Intel (INTC: Research, Estimates), Texas Instruments (TXN: Research, Estimates) and Xilinx (XLNX: Research, Estimates). He doesn't own the stocks but Morgan Stanley has investment banking relationships with the companies. A day later, the Merrill Lynch semiconductor team upgraded fourteen chip stocks, including Intel, Analog Devices (ADI: Research, Estimates), Broadcom (BRCM: Research, Estimates), and Taiwan Semiconductor (TSM: Research, Estimates). Merrill does investment banking for several of the companies in the chip sector.

The Philadelphia Semiconductor Index fell slightly following Edelstone's call on Wednesday but rose a modest 1.2 percent on Thursday, bucking the direction of the broader market.

Investors might not be all that enthusiastic about the upgrades because neither firm mentioned an imminent improvement in the economy as a reason for them. In fact, Merrill merely upgraded seven stocks from a "Sell" rating to "Neutral".

Semi history lesson Big chip stocks don't look that cheap when you look at historical valuations. Company P/E (Trailing 12-months) P/E (10-yr Avg) Intel 32.9 25.3 Texas Instruments 74.6 42.9 Maxim Integrated Products 40.1 40.3 Analog Devices 44.8 36.5 Xilinx 47.0 44.7 * as of 2/19/03 Source: Thomson/Baseline

This comment from the Merrill report hardly inspires confidence. "Evidence of a recovery in demand remains very thin - that is not the basis for our call," wrote the Merrill analysts. And Edelstone said in his report about Intel that at best, IT spending would probably be up 3 percent this year, with most of the spending coming in the second half of this year.

The primary reason that Morgan and Merrill upgraded the chip stocks was that they felt valuations are reasonable. And that's a subject open to debate on Wall Street.

Adam Parker, a semiconductor analyst with Bernstein, which does no investment banking, is not rushing to upgrade chip stocks yet. " I don't think they are screamingly cheap," he says.

Parker says that is more important to look at the fundamentals of each chip stock and compare valuation to where those stocks have traded compared to other points in their history.

More on chips National Semi to cut 500 jobs Micron cuts 1800 jobs Dell results boost chips Intel lowers capital spending outlook

For example, he says that Intel doesn't deserve a big premium to its historical earnings multiple because its revenue growth and gross margin expansion is likely to slow. But Intel is currently trading at about 33 times trailing earnings, a 30 percent premium to its 10-year average P/E of 25 times earnings. Parker is not recommending shares of Intel.

But Parker does have a buy on Analog Devices, even though it is trading at 45 times trailing earnings, a 20 percent premium to its 10-year average multiple of 36.5. That's because Parker thinks that fundamentals are improving.

To that end, Analog Devices reported better than expected earnings and sales in its latest quarter, citing solid demand for chips that are used in cell phones and digital cameras. Basically, he's willing to tolerate a higher multiple if the company is clicking.

"Analog Devices looks expensive but I recommend it because unlike Intel, it is a better company than it has been historically. It has a chance to improve margins and revenues are growing faster than the industry," Parker says.

Alex Vallecillo, senior portfolio manager with National City Investments, subadvisor of the Armada family of mutual funds, says he does not dispute the valuation call that the Morgan and Merrill analysts made. He also thinks chip stock prices are more reasonable than they were a few months ago. But that's not enough to justify loading up on chip stocks now, he says.

Vallecillo thinks that the fundamentals for chip stocks aren't likely to get much better for at least another two quarters. So even though the stocks may seem attractive now, they could wind up falling even further. "The ideal place to buy these stocks is about 20 to 30 percent lower than where they are now," Vallecillo says.

One major wild card though is next Tuesday's earnings report by Hewlett-Packard (HPQ: Research, Estimates). The Philadelphia Semiconductor Index shot up 5.8 percent last Friday after Dell Computer gave a fairly upbeat outlook. Hewlett-Packard, like Dell, is a major customer for chip companies. So if HP also gives some indication that things are getting better, than that would be stronger evidence of a true turnaround, Vallecillo says.

But chip companies are still grappling with the relatively weak demand for their products. National Semiconductor (NSM: Research, Estimates) announced on Thursday that it plans to lay off 500 people, about 5 percent of its workforce. That news comes on the heels of Tuesday's job cut announcement by Micron Technology (MU: Research, Estimates), which is going to lay off 1800 workers, about 10 percent of its employees.