Taking Stock: Watch Shifting Sands Of Tech ValuationsTaking Stock: Watch Shifting Sands Of Tech Valuations

Now that we've gotten past the goblins of Halloween, we must deal with the really scary aspect of the stock market: technology valuations. We already know that price momentum can carry far beyond traditional value metrics within the tech sector. How can this happen? Pretty easily.

First, we always have to consider money flow, or simply supply and demand for these stocks. When there's strong demand, stockholders will sell only if they get an attractive price. Attractive is usually defined as something substantially higher than their cost basis. This causes upward pressure on the stock price as money flows into the equity markets.

Second, we hear that today's "trough" valuations are meaningless, that the estimate of earnings per share is understated since we're in the early stages of an economic recovery. Any current price-to-earnings multiple that is implied, of course, will look high since earnings per share--the denominator--is low. But the company's earnings will grow, resulting in a more normalized, lower P/E multiple as earnings per share rise. Maybe.

Third, investor sentiment is strong. Common wisdom has it that one has to be invested in technology to make money going forward. I, like most investors, believe technology is going to be an ever-growing force in the global economy. However, unlike some investors, I believe there's a limit to where valuations should go to reflect the potential growth rates of the companies that sell or implement technological innovation.

Fourth, when the market is moving upward strongly, equity traders tend to be active in technology issues. Small changes, either in money flow, sentiment, or fundamentals, can have a dramatic impact on a company's share price. This is a trader's dream. You can see how volatile technology can be by looking at the average beta of a technology stock. The beta represents how volatile the stock price is relative to a broader market index such as the Standard & Poor's 500. For example, Texas Instruments, a popular semiconductor stock, has a trailing 180-day beta of 1.73. This means for every 1% move in the broader index, its stock is likely to move 1.73%. If you trade stocks, technology is the sector in which you may want to play.

But let's assume that we're actually investors and not traders. This is where it gets tricky. If we own large percentages of technology in general, or one or two large positions, then it might be time to consider taking some profits. That doesn't mean selling all tech stocks; taking some money off the table really does make sense because I believe the implied risk of ownership has increased dramatically relative to your future potential return. Since you aren't in the habit of making economic calls, and no one knows how robust our economy might be, it makes sense to pare down. In fact, you might take the proceeds from your sale and look at some beaten-down equity sectors such as health care and utilities. Who knows? Those might be where sentiment, money flow, and fundamentals improve next.

William Schaff is chief investment officer at Bay Isle Financial LLC, which manages the information 100 Stock Index. Reach him at [email protected]. This article is provided for information purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security. Bay Isle has no affiliation with, nor does it receive compensation from, any of the companies mentioned above. Bay Isle's current client portfolios may own publicly traded securities in one or more of these companies at any given time.

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