RIP semiconductor rally?

Unlock the Editor’s Digest for free

Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

Good morning. Yesterday’s letter praised Federal Reserve chair Jay Powell’s confidence in the economic expansion. Our timing was perfect as usual. Just a few hours after we published, a particularly ugly manufacturing ISM report landed. The employment subcomponent of the index was the weakest bit. A rough day on markets followed, especially for semiconductor stocks (see below), which had gotten a scare from some poor earnings reports. Things got no better when, after the markets closed, Amazon reported a solid quarter but an underwhelming forecast. Worse, Intel’s earnings report was a horror. Apple’s numbers were fine, thank goodness. It’s a lot to process. Please email with a tidy interpretation: [email protected] and [email protected].

Semiconductor companies

Back in June, Unhedged wrote about how a third big support for the rally in the S&P 500 — after the Big Tech platforms and AI chipmaker Nvidia — was other semiconductor companies. Recently the picture has become less rosy, though. Stock volatility has risen sharply across the sector, and there have been some poor quarterly results.

Just yesterday, shares of Arm and Qualcomm fell 16 per cent and 15 per cent, respectively, after providing third-quarter outlooks implying that the mobile device market is only treading water. Intel, which reported after yesterday’s close, said it expected to make a loss in the third quarter and was cutting both its dividend and thousands of jobs. The company mentioned “challenging” second-half trends and the impact of overcapacity. Its shares fell 19 per cent in late trading (after falling 5 per cent during the day).

Has one of the market’s legs been kicked out from under it?

Since the broad market bottomed in late 2022, semiconductor stocks have been on an absolute rip. Here is the performance of the Philadelphia Semiconductor index and the S&P 500:

Is this astonishing run grounded in improving fundamentals, or in exuberance? Has there perhaps been an AI halo effect, covering even semiconductor companies that do not have much to gain from the AI investment boom?

Here is a table of the nine largest US semiconductor companies by market cap, showing how much their shares have risen and how much their valuations have expanded over the past two years or so:

With the exception of Nvidia and Micron, higher price/earnings valuations have accounted for the better part of the rise in stock prices.

For most sectors, such a ballooning of valuations would be a sign of dangerous exuberance. But because most of the semiconductor industry is highly cyclical, valuations must be read carefully. Earnings vary by a huge amount, often turning negative at the low point in the cycle even at good-quality companies. This means that price/earnings ratios can be very high simply because the “E” in the ratio is at a low, rather than because the “P” has risen too much. Conversely, a chip stock with a very low P/E ratio can be very expensive, because earnings are at a cyclical peak and are about to turn down.

To make matters more complicated, there are different cycles for different kinds of chips — mobile chips from Arm and Qualcomm, processors from Intel and AMD, analogue chips for industrial applications from Texas Instruments and Analog Devices, Micron’s memory chips, and so on. Meanwhile, Nvidia (and to an extent Broadcom) are taking part in an AI gold rush that is a cycle all its own.

Here is a chart of revenue growth at those same companies (less Nvidia, whose stonking growth makes it hard to chart alongside anyone else):

There is, to use the technical term, a lot of spaghetti in this chart, but one can still make out a broad semiconductor cycle within it. Things were on the upswing in the late teens, but already turning down when Covid-19 hit. The pandemic was rough at first, but turned into a bonanza as lockdown boosted sales of electronics of all sorts. That boom faded in late 2022 and into 2023 as over-shipping and overcapacity hit and demand faded.

Now things are turning up again — maybe.

Memory prices have recovered strongly since late last year, and so Micron revenue (and its shares) have rebounded. After that, the picture is more complicated. Stacy Rasgon of Bernstein Research pointed out to me that shares in Analog Devices and Texas Instruments have risen on anticipation that second-quarter revenues will mark the low. But “the recovery has to come through” he says; NXP, a competitor, recently reported lukewarm results. Meanwhile, Intel’s results don’t speak to strong personal computer sales.

While the chart above may suggest a cyclical bottom, recent results suggest the group is hanging on thanks to AI and, to a lesser extent, computer memory prices which may have peaked already.

As Chris Caso of Wolfe Research explained to me, this cycle is hard to read not only because the pandemic interrupted and rebooted it. The AI boom also took hold just as the post-pandemic downturn was ending, in late 2022. It is not clear that this cycle will play out anything like earlier ones.

There is, however, a pretty good argument for looking past the puzzles of the current moment. While the past few years have been unusually strong, the semiconductor outperformance story is bigger and older than that, extending back at least to 2016:

The silicon intensity of the world economy is increasing — similar to the way the steel intensity of the world economy increased in the last century. But the chip business is a much better business than steel, with higher barriers to entry. Whatever the cyclical story may be today, that secular story is still in place. If what looked like a cyclical recovery turns into a downturn, that’s an opportunity.

One good read

HURRAH.