PXQ is Flying High: Watch Out for Sharp Fall

Since bottoming out to an all-time low in mid-summer 2006, PowerShares Dynamic Networking Portfolio (PXQ) has posted dramatic gains, with a 53.2% return (through Nov. 5) since July 21 of last year.

PXQ is only a few months past its second birthday, so it didn’t live through the bloodbath earlier this decade that struck the stocks of firms that build the backbone of the information economy. When the Internet bubble burst, stocks of firms that make fiber-optic lines, communications equipment and other data transmission tools were among the hardest hit—and the slowest to recover.

The sector finally started climbing back in 2005 and much of 2006, when telecom firms started to spend again. As they improved wireless networks and positioned themselves for new technologies tied to Internet broadband and video content, networking firms benefited from an upswing in spending. Sector bellwether Cisco Systems (CSCO), PXQ’s fifth-largest holding, bottomed out in March of 2001, then gained just 8.3% through the end of 2005. Share prices have just about doubled since then, however.

The rise of networking stocks has only intensified in 2007, as PXQ gained nearly 23% (through Nov. 5), based on very strong results from some key holdings.

Over the last three weeks, PXQ jumped four spots up the Sector Momentum Table, moving to No. 13 last week. The 17th ranking (Sept. 26–Oct. 17) was the fund’s lowest point in 2007. In fact, PXQ hasn’t been in the bottom half of the table since August of 2006.

It hasn’t all been rosy for the sector. Spending by telecom providers is slowing, especially on wireless, which hurt recent profits, according to S&P. The jury’s out on what telecoms will do going forward, though: Research firm Infonetics expects a 13% increase for 2007 over 2005, to $225 billion.

Networking stocks have a broader customer base than they did in the late 1990s, however, and sales to another group—enterprise, or the businesses, hospitals and universities that are spending to upgrade networks—are picking up, according to S&P and several recent earnings reports.

Demand for networking is up as enterprise customers scramble for capacity, needed to transmit video and other “Web 2.0” content that’s fast becoming ubiquitous as more and more people move toward video- and photo-sharing sites as well as social networking. Video traffic “is probably the most important growth driver for the future,” according to S&P equity analyst Ari Bensinger [Source: Businessweek.com].

Bensinger also told BusinessWeek that because the last large-scale communications upgrade movement was in 1999, more will come. He expects a “long-term upgrade cycle” fueled by the need to replace equipment from pre-2000 that’s nearing the end of its useful life.

PXQ is loaded with stocks that have gotten a boost from and seem positioned to benefit from both trends. Cisco, whose shares are up 22.7% year to date, is a perfect example, as is No. 4 holding Juniper Networks (JNPR), a stock that struggled more than most to escape the tech bust. After losing ground in 2005 and 2006, Juniper shares are up 84.9% year to date, as the company’s focus on high-end gear paid off in third-quarter sales growth of 28%, sending earnings up 22%.

In a recent interview, Juniper CEO Scott Kreines summed up the importance of networks today thus: “It’s becoming more than just a utility or a technology. It’s becoming a tool that drives the business success of a high-performance business—particularly with information dependencies, such as financial services or service providers, where the business is the network.”

Networking bulls share his sentiments, arguing that no matter what the forecasts say, businesses of all sizes are becoming more reliant on networking technologies to support their operations. As a result, they’ll keep spending to repair and upgrade their networks.

Top holding Citrix (CTXS) has also been a top performer, with shares up 57% year to date. The business software firm is focused on a popular niche, remote access and virtualization, and posted a 39% gain in quarterly net income last month.

As with the rest of the market, the biggest threat to PXQ is a major economic slowdown, which is on the minds of many investors. The tech sector and networking stocks strolled through this summer’s crises relatively easily, given that they enjoy separation from the real estate and financial sectors.

Still, this is a volatile fund, in a field that’s shown tremendous gains when conditions are right but that can go the other way in a downturn. Prior to hitting bottom back in July 2006, PXQ fell 25.5% in less than three months. It also fell 14.3% in a month this summer, when investors fled risk after the subprime crisis hit.