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Economic Headwinds Could Short Circuit Tech

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Since the bursting of the Internet bubble over a decade ago, technology stocks have been a relatively safe bet compared to the more volatile financial and energysectors.

But a bumpy last month shows that plenty of risk remains in stocks ranging from chipmakers to Internet search, cloud storage and plain vanilla PCs and software.

Russ Koesterich, global chief investment strategist for iShares, is concerned that tech recently had been tamer than usual until April, when a sudden return to volatility highlighted the sector's risks. He notes that the sector fell 6.5 percent during the April downturn, while the broader market lost 4.25 percent.

Volatility returned to the tech sector with a vengeance in April as an index measuring Nasdaq 100 price swings rose 16 percent higher than the VIX, which measures the volatility of the S&P 500.

The spike was led by Apple’s nine-session losing streak ahead of its earnings release, a downtrend that shaved almost 19 percent off its value. Disappointing earnings results from Intel and Qualcomm also contributed to the 35 percent jump in risk in a two-week period.

The mood swing was accompanied by renewed concerns about slowing economic growth, especially in the U.S., and the risk of a broad recession in Europe.

Heightened risk doesn’t bode well for a sector favored by momentum investors and heavily driven by sentiment. Nor does a growing preference for cutting edge new technologies of smaller firms in cloud computing and advertising/search technology over the older, commoditized products produced by hardware and software makers likeDell and Oracle .

The PC may not be dead, but computer hardware no longer produces robust margins that induce investment.Dell, one of the last remaining U.S. PC makers following last fall’s exit by Hewlett-Packard , reported disappointing fourth-quarter results that missed expectations and guided estimates lower for the current quarter.

While Dell generated sales gains from its core enterprise business customers, it’s been hurt by weakness in government and consumer spending.

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“There is a real chance [volume in the] PC market will implode,’’ says Rob Lutts of Cabot Money Management in Salem, Mass. “Consumers are going to a different platform with tablets and smartphones.”

Dell shares are flat over the last six months compared with a gain of 10 percent for the Technology Sector SPDR , a tech-sector proxy. HP and Oracle are both down around 15 percent over the same span while iShares North American Technology-Software is up just 2 percent.

Budget-squeezed government buyers present a major hurdle not just for PC and software but all tech companies.

Tech research firm Gartner forecasts global government IT spending will contract in 2012 and 2013, driven by cutbacks in the euro zone, and sees U.S. government IT spending flat this year before declining in 2013.Computer Sciences, Dell and Verizon are among the 20 largest government suppliers, according to Washington Technology.

"We feel reduced government spending is a significant headwind, likely to last several years,” says Sean Randall of Wells Fargo Advisors.

Should the U.S. economy remain sluggish, businesses could be hesitant to increase capital spending, says John Toohey, a vice president of equity investments at fund manager USAA. He also points out that technology is still a cyclical business and could suffer through the later stages of the current business cycle.

Speaking of suffering, wireless providers, AT&T,and Sprint Nextel absorb subsidies of up to $400 per handset to sign up subscribers to Apple’s iPhone. Sprint has to pay Apple $15.5 billion over four years to offer the iPhone, and the company claims its subsidies are $200 higher than other carriers.

Wireless carriers are also facing enormous future capital spending to keep up with the explosion of data being transmitted over their networks, says Brian Rich of New York private equity firm Catalyst Investors.

Investors are noticing the challenges as iShares Dow Jones U.S. Telecommunications Index , which has a 37 percent weighting in the three carriers, has lagged the overall tech sector by 9 percentage points over the last six months.

What's more, certain segments of the tech industry could soon feel the effects of lower capacity utilization, says iShares Koesterich. Capacity utilization has fallen from 80 percent in August to a current 77 percent for the sector overall, and from 86 percent to 71 percent for the semiconductor segment.

“It does suggest too much free capacity, so pricing power may not be as great as investors believe,” says Randall.

While the sector as a whole trades close to its historical premium over the market, the prices being fetched for some of the more glamorous tech names like social game communityZynga and online couponer Groupon give some market watchers pause.

“It's hard to justify the valuations being given to some of these tech startups,’’ says Bill Hammer Jr. of wealth manager Vanderbilt Partners in Melville, N.Y. “This feels a lot like 2000 — overpaying for the next Facebook.”

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