Do professional investors think the technology bubble is about to burst?

Is there a bubble in the Technology sector? Post credit crunch we know that the ex UK Prime Minister was wrong to say that “the era of boom and bust is over”. Bubbles exist despite the efforts of short sellers whose contrarian views can limit them. Do professional investors foresee “Dotcom II”? We will look at the sector Long Short Ratio as well as these companies Salesforce.com (CRM), Rackspace (NYSE:RAX), Stec (NASDAQ:STEC), Autonomy (LSE:AU), iShares Global Technology ETF (IXN), Vanguard Information Technology (VGT) and SPDR Select Sector Technology ETF (XLK).

A new book called “The Road From Ruin” makes a good point that, with hindsight, bubbles are often linked to periods of innovation. Witness the US railway boom on the back of the industrial revolution and the Dotcom bubble at the birth of the internet age. However, human instinct is to get so excited by the breakthrough advancement of the day that we end up over estimating the effects of that innovation. In the end, the overshooting of expectation leads to a crash.

Back to the data. US Software companies are trading on an average P/E ratio of a staggering 88. Hardware firms see a P/E ratio of 40, but we will show that investors think that the bubble in the software arena is set to inflate further while the makers of the equipment and hardware are due some harder times.

The Data Explorers ratio of institutional ownership to shares being borrowed in the US Hardware & Equipment sector shows a trend of increased short selling which started in August last year. Overall, one should not suddenly think there is a wave of short selling in this sector – the average amount of a company being short sold is half the overall average at 1.1% - however the change is interesting. It is also the inverse pattern to what we see for Energy companies, where short selling has been reducing since last summer.

Interestingly, the sentiment in the Software & Services sector is less negative. 0.95% is the average proportion of these companies being borrowed so less than the hardware manufacturers. The conclusion is that, in the main, hedge funds do not believe that Software firms are overvalued, despite an aggregate P/E ratio of 88.

Encapsulating this state of affairs is Salesforce.com (NYSE:CRM). A year ago, this Software & Services firm was heavily short sold (12% of total shares outstanding on loan) and the shares were USD 60. Fast forward to today and shorting is 7% with the price at USD 130. The current P/E is over 200 but investors have been generally reducing their short positions meaning they are giving up trying to predict the top of the share price. Rackspace (NYSE:RAX) shows a similar pattern with short interest falling from 25% to 14% of total shares outstanding on loan, as the shares continue to defy gravity. Bucking the trend in this sector is the UK’s Autonomy Corp (LSE:AU). Stock on loan has recently doubled to 9% of all shares this year.

One of the most shorted in the hardware arena is solid-state drive maker – STEC (NASDAQ:STEC). With 33% of all shares on loan, this is a stock worth keeping an eye on.

Finally, a glance at the Technology ETFs provides a useful barometer of sentiment. IXN (iShares Global Technology) shows a recent spike in short selling, up from almost nothing over the last year to 0.5% of all shares. VGT (Vanguard Information Technology) shows shorts trending higher to a similar level. The SPDR ETF (XLK: Select Sector Technology) has seen a very recent increase, but overall there has been lots of short covering in this name from 10% to 2% of all shares.

The sky-high multiples that Software firms are trading on could be a reflection that they are not limited by the physical boundaries of making a tangible product – just consider Facebook’s USD50 billion valuation. Despite an increase in short selling in the hardware firms, it seems that investors are not predicting the imminent popping of the bubble. It remains to be seen whether their expectations have over shot.