Is the semiconductor rally over?

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Good morning. In yesterday’s letter, we praised Federal Reserve Chairman Jay Powell for his confidence in the expanding economy. As always, the timing was perfect. Just hours after we sent out the letter, a particularly awful ISM report for manufacturing was released. The employment subcomponent of the index was the weakest. Then the market had a tough day, with semiconductor stocks in particular spooked by some bad earnings reports (see below). After the market closed, Amazon reported solid quarterly results, but expectations were disappointing. To make matters worse, Intel’s earnings report was terrible. Thankfully, Apple’s numbers were fine. There’s a lot to process. Please email your neat interpretations to: robert.armstrong@ft.com and aiden.reiter@ft.com.

Semiconductor companies

In June, Unhedged wrote that other semiconductor companies were the third-biggest driver of the S&P 500 rally, behind big tech platform and AI chipmaker Nvidia. But things have been looking less rosy lately, with stock volatility spiking across the sector and some weak quarterly earnings.

Arm and Qualcomm shares fell 16% and 15%, respectively, yesterday after the companies released third-quarter outlooks showing a stagnant mobile device market. Intel, which announced after the close yesterday, said it expects to post a loss in the third quarter and will cut its dividend and thousands of jobs. The company cited “challenging” trends in the second half of the year and the impact of overcapacity. The company’s shares were down 19% in late trading (down 5% intraday).

Has one of the market’s legs been kicked away?

Semiconductor stocks have been surging since the broader market bottomed in late 2022. Below is the performance of the Philadelphia Semiconductor Index and the S&P 500.

Is this incredible rally due to improving fundamentals, or is it just enthusiasm? Is there an AI halo effect that is reaching even semiconductor companies that aren’t seeing much benefit from the AI ​​investment boom?

Below is a table of the top nine US semiconductor companies by market capitalization, showing how much their stock prices have risen and their valuations have expanded over the past two or so years.

With the exception of Nvidia and Micron, most of the stock price gains have come from higher price-to-earnings ratios.

For most sectors, such a sudden rise in valuations would be a sign of dangerous exuberance. However, valuations should be interpreted with caution because most of the semiconductor industry is highly cyclical. Earnings fluctuate widely and are often negative at cycle lows, even for blue-chip companies. That means that when price-to-earnings ratios are very high, it’s simply because the “E” of the ratio is low, not because the “P” has risen too high. Conversely, semiconductor stocks with very low P/E ratios can be very expensive because earnings are at a cyclical peak and about to fall.

To complicate things further, there are different cycles for each type of chip: mobile chips from Arm and Qualcomm, processors from Intel and AMD, industrial analog chips from Texas Instruments and Analog Devices, memory chips from Micron, etc. Meanwhile, Nvidia (and to some extent Broadcom) are participating in their own cycle: the AI ​​gold rush.

Below is a graph of revenue growth for the same companies (excluding Nvidia, whose phenomenal growth makes it hard to chart it alongside the others):

There’s a lot of spaghetti in this chart, to use the jargon, but we still see the broad semiconductor cycle within it. It was trending up in the late ’10s. But it was already trending down when COVID hit. The pandemic was tough at first, but the lockdowns boosted sales of all kinds of electronics, creating a bonanza. That boom faded in late 2022 and into 2023 as overshipments and excess capacity hit and demand waned.

Now, things are looking up again — maybe.

Memory prices have rebounded strongly since late last year, and Micron’s sales (and stock price) have recovered as well. Since then, the picture has become more complicated. Stacey Rasgon of Bernstein Research noted that Analog Devices and Texas Instruments shares have risen on expectations of second-quarter sales troughs. But, he said, “a recovery has to happen,” and rival NXP recently reported lackluster results. Meanwhile, Intel’s results don’t tell the tale of strong PC sales.

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

As Wolf Research’s Chris Caso explained to me, this cycle is hard to predict, and not just because it was interrupted and restarted by the pandemic: The AI ​​boom began in late 2022, just as the post-pandemic recession was winding down. It’s not clear whether this cycle will play out the same way as previous ones.

But there’s a pretty compelling argument to make for the current situation: While the past few years have been exceptionally strong, the story of semiconductor strength is larger than that, and dates back to at least 2016.

The silicon intensity of the global economy is increasing, similar to the increase in the steel intensity of the global economy over the last century. But the semiconductor business, while it has higher barriers to entry, is a much better business than steel. Whatever the business cycle story is today, the long-term story remains valid. When what appears to be a business cycle recovery turns to a downturn, it’s an opportunity.

Good read

Yay.

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