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Tech Battleground

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The semiconductor sector has been a place of tension recently. Those market participants betting on a rebound in the economy have been using chip shares as a medium to gain exposure to any forthcoming recovery in tech. Meanwhile, the other side of the market has been arguing that estimates among the chip issues remain too high and that the eventual recovery in the economy is still far off, perhaps more than a year.

The chip sector is an excellent gauge for the broader technology business because of the ubiquity of semiconductors. They're everywhere, from cell phones and computers to routers and video game consoles. As such, the Philadelphia Semiconductor Sector Index (SOX.X) is a good leading indicator of the broader technology segment of the market and an equally good playing field for The Bulls versus The Bears best of 7 series.

The SOX was knocked down Monday morning on the heels of the Lehman downgrade of more than a dozen capital equipment companies. Lehman lowered its ratings on notables such as Applied Materials (NASDAQ:AMAT), Novellus (NASDAQ:NVLS), and KLA-Tencor (NASDAQ:KLAC) -- all of which are components of the SOX.

Appropriately enough, Novellus reports third-quarter numbers after the bell, with estimates calling for $299 million in revenues and 24 cents per share in earnings. But perhaps more interesting than the actual third-quarter numbers will be the company's forecast and comments on a recovery in demand. You see, Novellus is a chip equipment manufacturer that supplies products to microprocessor producers, and a pickup in equipment manufacturers' orders generally leads a pickup in actual chip demand.

And the big dog amongst chip makers, Intel (NASDAQ:INTC), reports after the bell tomorrow. Estimates have come down quite a bit for Intel over the past few months. The company is expected to report 10 cents per share and revenues of around $6.4 billion. Intel may have lowered the bar enough and taken enough market share from Advanced Micro (NYSE:AMD) recently to "trip" over its numbers. But, the important point of Intel's report will be its comments on the potential for a recovery in the microprocessor business.

The guidance from Novellus and Intel, among other chip-related companies, will be more important over the short-term than the Lehman downgrade Monday morning. In fact, at this point, I don't give the Lehman downgrade too much credence, judging by the price action of the SOX. The SOX advanced from roughly the 350 level to 475 in the space of about two weeks -- that's a 35 percent run! Such an incredible move requires consolidation, backing, and filling. So for the SOX to give back roughly 25 points (at the time of this writing) off the Lehman downgrade is routine. In fact, I think a pullback down into the 400 to 425 range over the next few weeks would be perfectly natural.

While I might consider shorting some of the weaker components of the SOX if I believed the index is going to shed another 25 to 50 points from current levels, I wouldn't turn bearish, per se, on the sector unless it broke down below the 400 level.

But much of the SOX's price action over the next few weeks is going to be predicated on earnings reports and guidance. After all, who knows the business better than the participants themselves? Positive comments from a few of the equipment makers, such as Novellus, and the chip manufacturers, such as Intel, could negate the Lehman downgrade Monday and carry the SOX higher over the short-term. But if Lehman was correct about the potential for the chip downturn to last well into 2003, then we're likely to hear cautios comments from the likes of Novellus and Intel over the next few weeks.

In either case, the price action of the SOX should be telling of the health of the broader technology segment over the short-term. That includes the box makers, networkers, hardware manufacturers, and Internet and software concerns to a lesser extent.

Eric Utley
Option Investor

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