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The world's largest chip equipment maker, Applied Materials (NASDAQ:AMAT), reported fiscal first-quarter numbers Tuesday night that appeased investors. Excluding charges, analysts expected the company to break-even. Applied Materials exceeded expectations by posting a 2 cent profit.

On the conference call, I heard a tone of muted optimism. The company said that orders would grow sequentially by about 10 to 15 percent. Company officials reaffirmed next quarter expectations for $1 billion in revenue and profitability, while leaving room for upside. Applied Materials' officials were optimistic about the future and the adoption of new technologies, which is expected to drive growth this year.

Wall Street's reception of the earnings report was mixed to bullish. Thomas Weisel was the most bullish, reaffirming its one year price target of $75 following the conference call. Others, such as UBS Warburg, opined that the modestly good news had already been priced into the stock. Through the time of writing, shares of Applied Materials were higher by 6.50 percent.

Applied Materials tried to paint an upbeat picture about end-market demand and growth through new technologies. But it remains to be seen when demand fully recovers. And let's be realistic, demand is not going to recover to the levels seen two and three years ago during the go-go years. The rate at which demand recovers and the absolute level will ultimately determine Applied Materials' earnings growth. As the company reaffirmed last night, it should see a 10 to 15 percent rise in orders. That's not the type of growth that supports a stock at 215 times this year's earnings.

That's right, through Tuesday, shares of Applied Materials trade for 215 times this year's earnings. The valuation issue is a big one among chip shares currently. It's not 1999 anymore and valuations do matter over the long-term.

Sexy SOX

The semiconductor sector is much-loved by investors. Chips are ubiquitous. They are used in automobiles, consumer products, and networking equipment, among so many other applications. If you're bullish on tech, right or wrong, you're going with chips. But is it right or wrong to be bullish on chip shares right here and now?

Using more of an intermediate-term perspective, the Philly Semiconductor Sector (SOX.X) bumped into a meaningful resistance level earlier today. The chart below employs a 10 point box. It gives me a better look of the intermediate-term happenings in chip shares.

SOX.X - 10 Point Box

The SOX traded up to the 560 resistance level -- it's meaningful resistance for the double-top as well as the bearish resistance line. It remains to be seen if the SOX can break above its resistance. That break would come on a print at 570.00, which could happen today or later this week. If the SOX does in fact advance past 570.00, I think that would be a short-term bullish development, one that could be quickly traded to the upside. However, if the SOX fails to print 570.00 in its current leg higher, then I think it reveals a belief by the market that the chips are too expensive to merit a breakout. From there, the chips could mark time (Read: Trade Sideways) at current levels or pullback.

Relative strength readings of the SOX versus the market reveal the sideways trading notion, perhaps even reinforce the idea. In terms of relative strength, the SOX peaked versus the S&P 500 (SPX.X) in December. The group hasn't been able to gain ground since that time, failing to advance past the 50.00 relative strength reading for two months now. In today's session, the SOX once again advanced to the 50.00 mark.

Relative Strength - SOX.X versus SPX.X

Perusing individual stocks in the semiconductor group, I've found more indecision on the part of the market, perhaps echoing the relative strength readings.

Micron (NYSE:MU), love it or hate it, is the maker of dynamic random access memory (DRAM). Micron's DRAM business accounts for about 87 percent of sales. From a technical perspective, the stock broke out from a bullish triangle earlier this week and is continuing higher today. The bullish triangle is one of the strongest patterns in the point and figure methodology. Ironically enough, Micron traced a bullish triangle through last October and you can see where that pattern carried the stock.

Micron - Bullish Triangle

PMC-Sierra (NASDAQ:PMCS) is a supplier of chips for use in high speed broadband applications. It's a supplier of networking equipment chips to customers such as Cisco Systems (NASDAQ:CSCO). The stock is another in the chip group that trades in a triangle. Unlike Micron, PMCS has not yet broken from its triangle. PMCS' is still neutral. The stock is currently six columns deep into its consolidation.

PMC-Sierra - Neutral Triangle

Integrated Device Technology (NASDAQ:IDTI) is probably the most diversified of the three chip companies discussed herein. The company's products are used in networking equipment, cellular base stations, storage area network applications, and personal computers. It, too, has traced a triangle through Wednesday's session.

Integrated Device Technology - Neutral Triangle

Chip Summary

Taking into account our observations, it seems to me that the SOX is at an inflection point where it could trade measurably higher or reverse much lower. I don't know which way the market is going to take the group. Using the Micron -- a bellwether in the sector -- triangle as a guide, one might adopt a bullish stance. The Applied Materials' guidance and valuation variable, however, may beg bearishness over the intermediate-term.

The triangles, one bullish, in the three different stocks discussed also point to a forthcoming move in the group. It's worth noting that the three companies highlighted are quite different in business lines and product offerings, providing a broader view of the group.

If Micron's bullish triangle is a leading indicator for the group, then we could see an advance in relative strength and witness additional meaningful breakouts in the group. Conversely, if the SOX fails to print 570.00 and loses relative strength from current levels, then Micron's triangle could've been a bull trap and we may witness another measurable pullback in the group. There are several actionable set-ups in the SOX currently, which in my mind warrant watching closely such as the triangles in PMC-Sierra and Integrated. If you do some digging, you'll find other set-ups among chip shares.

The point and figure charts that appear in this piece were created using www.StockCharts.com.

Eric Utley
Option Investor

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