Rest in peace for the semiconductor rally?

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

Good morning. From yesterday. letter We praise Federal Reserve Chairman Jay Powell’s confidence in the economic expansion. The timing was perfect, as always. Just hours after our publication, a particularly striking report ugly The ISM manufacturing report came to a close. The employment subcomponent of the index was the weakest. A rough day followed in the markets, especially for semiconductor stocks (see below), which had been spooked by some poor earnings reports. Things did not improve when, after the markets closed, Amazon reported a solid quarter but a Disappointing forecast. Worse still, Intel’s earnings report It was a horror. Apple’s numbers were fine, thank God. It’s a lot to process. Please send an email with a clear interpretation: robert.armstrong@ft.com and aiden.reiter@ft.com.

Semiconductor companies

Back in June, no coverage wrote about The third major support for the S&P 500’s rally, after Big Tech platforms and AI chipmaker Nvidia, were other semiconductor companies. However, the picture has become less optimistic recently. 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% and 15% respectively after offering their third-quarter guidance, suggesting that the mobile market is stagnant. Intel, which reported its results after the close yesterday, said it expected to post a loss in the third quarter and was cutting both its dividend and thousands of jobs. The company cited “challenging” second-half trends and the impact of overcapacity. Its shares fell 19% in after-hours trading (after falling 5% during the day).

Has the market been kicked in the foot?

Since the broader market bottomed in late 2022, semiconductor stocks have been on a bullish streak. Here is how the Philadelphia Semiconductor Index and the S&P 500 have performed:

Is this surprising run due to improving economic fundamentals or over-enthusiasm? Has there perhaps been a halo effect on AI, affecting even semiconductor companies that don’t have much to gain from the AI ​​investment boom?

Below is a table of the nine largest U.S. semiconductor companies by market capitalization, showing how much their stocks 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 most of the rise in stock prices.

For most sectors, such a large increase in valuations would be a sign of dangerous exuberance, but since most of the semiconductor industry is highly cyclical, valuations need to be read carefully. Earnings vary wildly and often turn negative at the trough of the cycle, even for good quality companies. This means that price/earnings 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 much. Conversely, a chip stock with a very low price/earnings ratio can be very expensive, because earnings are at a cyclical peak and are about to turn lower.

To make matters more complicated, there are different cycles for different types of chips: mobile chips from Arm and Qualcomm, processors from Intel and AMD, analog chips for industrial applications 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 unto itself.

Here’s a chart of revenue growth for those same companies (minus Nvidia, whose astonishing growth makes it difficult to chart alongside any others):

There is, to use the technical term, a lot of spaghetti in this chart, but you can still discern a broad semiconductor cycle in it. Things were booming in the late 1920s, but they were already slowing down when COVID-19 hit. The pandemic was tough at first, but it turned into a bonanza as lockdowns boosted sales of electronics of all kinds. That boom faded in late 2022 and 2023 as overshipments and overcapacity took hold and demand faded.

Now things are looking up again, perhaps.

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

While the chart above may suggest a cyclical bottom, recent performance suggests the group is being sustained by AI 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 difficult to interpret, not only because the pandemic interrupted and restarted it, but because the rise of AI also took hold just as the post-pandemic recession was ending, in late 2022. It’s not clear that this cycle will play out in a similar way to previous ones.

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

Silicon intensity in the global economy is increasing, much as steel intensity in the global economy increased over the past century. But the chip business is a much better business than the steel business, with higher barriers to entry. Whatever the current cyclical story, that secular story still holds true. If what looked like a cyclical recovery turns into a recession, that’s an opportunity.

A good read

HURRAH.