Billionaire investor Jim Rogers may be most famous for calling the bottom of the commodities market and buying in 1999, just before it surged 22% during the following three years while the S&P 500 lost almost 40% in the same period.

But the co-founder of the Quantum Funds with George Soros could be just as famous for some of his warnings. In a 2007 interview with Reuters, Rogers predicted a 40-50% drop in real estate prices in some areas of the United States and a massive recession across the country.

We all know how that prediction turned out.

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So it’s no surprise investors take note when the legendary investor makes any market prediction. And Rogers is now warning that one sector of the market is “priced in lunacy,” so he is betting heavily against the group. The sector has seen earnings fall by 4.3% in the third quarter compared with the same period last year, almost double the decline of 2.2% for the overall market.

So which sector could be headed for a big drop?

Rogers is talking about technology.

Bears have a lot to growl about…
To be sure, there are several reasons the technology sector is due for a correction. The sector outperformed all others during the past four years with an annualized gain of 19%, while the S&P 500 Index gained 12% in the same period. This outperformance may already be working itself out with a drop of 10% so far this quarter compared with a decline of 6% in the rest of the market.

In terms of valuation, the stocks in the Technology Select Sector SPDR (NYSE: XLK), for example, currently trade for about 13 times trailing earnings, which is right at the average for the overall market, but higher than that of the financials and energy sectors. And dividend yields are not as good either. While many of the big players such as Microsoft (Nasdaq: MSFT) and Apple (Nasdaq: AAPL) have started to pay dividends, the sector as a whole only pays a 1.7% dividend yield compared to an average of 2.1% in the overall market.

Of more concern, four years after the financial collapse, U.S. companies have yet to really ramp up hiring. While Europe and China are looking incrementally better, the United States is facing a huge fiscal gap in the coming quarters, with even the most optimistic forecasts only calling for about 1.5% gross domestic product growth. With labor already cut to the bone, companies are putting off improvements in tech spending ahead of the fiscal and economic uncertainty.

One big clue to the level of frothiness in the tech sector could be coming from the rebound in real estate prices in Silicon Valley. Real estate has soared in the tech capital and prices are off their peak by just 1.3% in some cities, while much of the rest of the state continues to struggle with foreclosures. 

Bulls still have room to run in individual stocks
There may yet be hope for the sector. Tech companies in the United States earn more revenue outside U.S. borders than any other sector, making the tech industry more resistant to fiscal cliff worries and weakness here at home. Revenue should be marginally supported if Europe can stage a rebound or if emerging markets continue their economic march higher.

President Barack Obama will need to barter with Congress if he wants to let the Bush-era tax cuts expire for those making more than $250,000 a year. One possible deal could revolve around another tax repatriation holiday like we saw in 2004. Under a repatriation holiday, U.S. companies are lured to bring foreign profits back to the country by taxing them at a roughly 5% tax rate, rather than the current 35% corporate rate. Because the tech sector has the most overseas revenue, it also has the most cash held overseas, so it could win big with such a tax holiday.

In addition, Microsoft launched Windows 8 in October and will stop supporting Windows XP in early-2014. This could reinvigorate the corporate spending cycle for information technology (IT) and services. Further, if demand in fact rebounds, then tech spending usually leads the business cycle because it is easier to buy IT and services than to add staff.

Quality and value vs. hopes and dreams
Even Rogers admits there will always be success stories, but the problem is when an entire sector is pushed up without any real difference between the good and the bad. This was evident in some of this year’s catastrophic IPOs — Facebook (Nasdaq: FB) and Groupon (Nasdaq: GRPN).

Investors seem to have forgotten the lessons of the 2000 tech bubble, and are now paying meteoric prices for very little in earnings. While Groupon and Facebook have seen their shares sink since their IPOs, shares of LinkedIn (NYSE: LNKD) are up almost 10% since its offering in May 2011. LinkedIn is basically Facebook for professionals and does not command nearly the audience, so why is it that shares are trading for more than 665 times trailing earnings? Only a handful of other stocks in the market trade so expensively, and they are all small or mid-cap companies. Earnings are down during the last two quarters and the company has yet to present a clear strategy to monetize on mobile usage.

While there are plenty more examples of unrealistic prices in the tech sector, there are also some good deals. I wrote in September about the once-in-a-decade opportunity in Intel (Nasdaq: INTC). The shares trade for just 8.8 times earnings and pay a 4.5% dividend yield. Investors are worried that the emergence of smartphones and tablets will make PCs obsolete, but, as I mentioned before, there are several catalysts coming next year that could send the stock dramatically higher. The company is extremely well-run, with an operating margin higher than 95% of peers in the industry and has bought back $1.4 million in shares this past quarter.

Risks to Consider: Half of investing is keeping your profits before the bottom drops out of the market. Companies with strong balance sheets and good value should do well during the next year, but may see a short-term drop as investors take the entire sector lower. Investors should be ready for a short decline on sentiment before stronger stocks head higher.

Action to Take –> After years of outperformance, the tech sector could be due for a correction, as Rogers expects. You may not want to neglect the entire sector, but be selective and know when to take your money off the table. Given the valuations in much of the sector, investors may want to avoid some of the more expensive stocks and the general sector funds. For those who do not want to completely avoid the sector, look for large-cap companies with strong balance sheets that pay healthy dividends such as Intel.