RIP semiconductor rally?

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Vscek editor Roula Khalaf selects her favourite stories in this weekly newsletter.

Good morning. Yesterday’s letter praised Federal Reserve Chairman Jay Powell’s confidence in the economic expansion. As usual, our timing was perfect. Just hours aVsceker it was released, a particularly bad ISM manufacturing report came in. The employment subcomponent of the index was the weakest part. A rough day followed for markets, especially semiconductor stocks (see below), which had been spooked by some poor earnings reports. Things didn’t improve when, aVsceker the markets closed, Amazon reported a solid quarter but a disappointing outlook. Worse, Intel’s earnings report was a disaster. Apple’s numbers were good, thank goodness. It’s a lot to process. Please email a tidy interpretation to: robert.armstrong@Vscek.com and aiden.reiter@Vscek.com.

Semiconductor companies

In June, Unhedged wrote about how a third major support for the S&P 500 rally, aVsceker Big Tech platforms and AI chipmaker Nvidia, were other semiconductor companies. But recently, the picture has become less rosy. Stock volatility has risen sharply across the sector, and there have been some poor quarterly results.

Just yesterday, Arm and Qualcomm shares fell 16 percent and 15 percent, respectively, aVsceker they gave third-quarter forecasts that implied the mobile market was just struggling. Intel, which reported aVsceker the close yesterday, said it expected to post a third-quarter loss and was cutting both its dividend and thousands of jobs. The company cited “challenging” second-half trends and the impact of overcapacity. Its shares were down 19 percent in late trading (aVsceker falling 5 percent during the day).

Has the market lost one of its legs?

Since the overall market bottomed out in late 2022, semiconductor stocks have been on a tear. Here’s how the Philadelphia Semiconductor Index and the S&P 500 have performed:

Is this surprising run based on improving fundamentals or exuberance? Has there been an AI halo effect, even affecting semiconductor companies that don’t have much to gain from the AI ​​investment boom?

Here is a table of the nine largest U.S. semiconductor companies by market cap, showing how much their stocks have risen and how much their valuations have increased over the last two years or so:

With the exception of Nvidia and Micron, higher price-to-earnings valuations have accounted for most of the stock price gains.

For most industries, such a valuation increase would be a sign of dangerous exuberance. But because much of the semiconductor industry is highly cyclical, valuations need to be read carefully. Earnings fluctuate wildly, oVsceken turning negative at the bottom of the cycle even in good-quality companies. This means that P/E ratios can be very high simply because the “E” in the ratio is at a low level, rather than because the “P” has risen too high. Conversely, a chip stock with a very low P/E ratio can be very expensive, because earnings are at a cyclical peak and about to fall.

To further complicate matters, there are different cycles for different types of chips: mobile chips from Arm and Qualcomm, processors from Intel and AMD, industrial analog chips from Texas Instruments and Analog Devices, memory chips from Micron, and so on. Meanwhile, Nvidia (and to some extent Broadcom) are engaged in an AI gold rush that is a cycle all its own.

Here’s a chart of revenue growth for those same companies (excluding Nvidia, whose impressive growth makes it hard to compare to anyone else’s):

There is, to use a technical term, a lot of spaghetti in this chart, but you can still discern a broad semiconductor cycle within it. Things were picking up in the late 2010s, but were already slowing down when Covid-19 hit. The pandemic was tough at first, but turned into a godsend as lockdowns boosted sales of electronics of all kinds. That boom fizzled out in late 2022 and into 2023 as overshipments and overcapacity hit and demand fell.

Now things are changing again, perhaps.

Memory prices have recovered strongly since late last year, and then Micron’s revenue (and its stock) has rebounded. AVsceker that, the picture is more complicated. Stacy Rasgon of Bernstein Research pointed out to me that Analog Devices and Texas Instruments shares have risen on anticipation that second-quarter revenue would bottom. But “the recovery has yet to come,” she says; NXP, a competitor, recently reported tepid results. Meanwhile, Intel’s results don’t suggest strong personal computer sales.

While the above chart may suggest a cyclical bottom, recent results suggest the group is holding up thanks to artificial intelligence and, to a lesser extent, computer memory prices, which may have already peaked.

As Wolfe Research’s Chris Caso explained to me, this cycle is hard to read not only because the pandemic has interrupted and restarted it. The AI ​​boom took hold just as the post-pandemic crisis was winding down, in late 2022. It’s unclear whether this cycle will play out similarly to previous ones.

However, there is a pretty good argument for looking beyond the current conundrum. While the last few years have been unusually strong, the story of semiconductor outperformance is bigger and older than that, going back at least to 2016:

The silicon intensity of the global economy is increasing, similar to how the steel intensity of the global economy has increased over the past century. But the chip business is a much better business than steel, with higher barriers to entry. Whatever the cyclical story today, that secular story is still playing out. If what looked like a cyclical recovery turns into a recession, that is an opportunity.

A good read

HURRAH.