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Networking Issues

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I received a lot of e-mails for tax-loss bounce candidates. Most of those requests included a few networking names. Not by surprise, and as I wrote in the earlier update, the networking sector is laden with poor performers this year. That's because telecom stinks.

Not all networking equipment makers are levered only to the telecom industry. For example, Cisco (NASDAQ:CSCO) derives a lot of its revenue from enterprise customers, which include businesses outside of telecom, schools, and other institutions. But the majority of equipment makers, for worse this year, are dependent on the telecom industry. The carriers are the ones who buy the equipment to build the networks on which they sell the services. But the carriers aren't buying a lot of equipment. The big equipment buyers in Verizon (NYSE:VZ), SBC Communications (NYSE:SBC), and Qwest (NYSE:Q) have all recently slashed capital expenditures for next year. Qwest recently announced a 50 percent reduction in spending!

Several factors have played into the demise of the telecom sector. Revenues from long distance have all but disappeared because rates are going to zero. The carriers have searched for other means of revenue through offering various bundled packages of voice and data services. But the end demand for those services has languished. Increased competition from the competitive local exchanges (CLECs) cut into the incumbents, but the CLEC model appears to be flawed. The recent and looming bankruptcies in the space reveal that much. Of course the dry capital markets didn't help those in need of funding.

The slide in demand from the carriers has plagued the equipment makers all year long and continues to do so. Just recently, Nortel (NYSE:NT), Juniper (NASDAQ:JNPR), Lucent (NYSE:LU), and Ciena (NASDAQ:CIEN) revealed the deteriorating conditions of the business. Of the major players in the group, only Cisco has stabilized, but that's only because the company is taking market share from the others. Aside from Cisco, smaller, niche players in the sector have weathered the slowdown in spending, such as Riverstone (NASDAQ:RSTN), whose equipment is used for revenue-generating services in the metro markets. But the fact remains that there's much less money to go around with the cuts in cap expenditures. In other words, demand stinks.

There haven't been any signs of stabilization in capital expenditures, which is why the consensus is calling for the networking equipment sector to continue to languish into next year. The AMEX Networking Sector Index (NWX) has under performed the broader tech space for the last eleven months! Although the NWX is higher today, it remains a difficult place to invest.

(NWX versus NDX)

Until the NWX gains ground relative to the rest of tech, I think the consensus is correct in that the sector is one to avoid. The price action of the NWX will tell investors when demand has returned and that business is better. But until we get a buy signal on the relative strength chart, the NWX should be cautiously approached by the bulls.

Yes, there exists the possibility that many networking equipment makers could bounce in the next several weeks as the tax-loss selling exhausts. But any such play on a bounce in the NWX should be approached with strict risk management.

Eric Utley
Option Investor

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