Security Risk

Security stocks, until recently one of the few Net sectors thought to be invincible, have begun to show signs of vulnerability.

Last week, Check Point Software gave back half of its 100% run-up after missing its whisper number and coming in light on estimates. And last night, Netegrity , one of the top-performing stocks of recent years, slipped after hours when it warned that second quarter earnings and revenues will be flat or down from the first quarter.

The sector has held up better than almost any other, both fundamentally and technically. But now even the leading security stocks have begun to be affected by the rapid slowdown in technology investment.

Investors have begun to look past negative earnings and preannouncements to an eventual economic recovery. Or at least that’s the mood investors were in in April.

But security stocks, like many issues that have led the Nasdaq’s recent recovery, are already priced for perfection. At about 60 times earnings, Check Point is almost a value stock in the sector. Netegrity is priced at about 200 times reported earnings, a steep valuation for a company with flat earnings. With an economic recovery likely some time away still, it’s hard to imagine what the near-term catalyst for further upside will be.

In addition to the forward guidance, traders also focused on the company’s slowing sequential revenue growth, which decelerated from the greater than 40% rate of recent quarters to 21%. That’s an impressive level of growth considering the huge year-over-year earnings declines in stocks like Cisco , but the slowing growth rate is also a sign that security stocks may not be immune from further weakness if the economy doesn’t begin to rebound in the next quarter or two.

A look at the charts of Check Point and Netegrity also reveals some potential warning signs. Netegrity (first chart) was rejected at a downtrend line recently. $30 is important support. And Check Point (second chart) may have formed an “island” reversal, separated by gaps, on its recent move down.

These are strong companies with good futures, and have fared better than the vast majority of technology and Internet issues over the last year. But their continued strength depends on whether the economic recovery investors have begun pricing into stocks begins to materialize in coming months. The good news for investors in these stocks is that the signs of slowing are appearing at a time when the market is beginning to look ahead to better times.