Equity Trade – Time to Short the Semiconductor Sector

Summary

• The strong equity rally in the S&P 500 (SPX) and particularly the NASDAQ 100 (NDX) has come amid declining earnings forecasts, and analysts have recently downgraded forecasts further.
• The semiconductor sector has been particularly robust even as earnings forecasts have fallen by 15% since the year began.
• We expect semiconductor companies to face strong headwinds in 2023. The drought in consumer electronics is expected to continue into 2024.
• The 2021-22 boom in corporate CAPEX is over; at best, 2023 CAPEX may increase in line with inflation.

Market Implications

• We expect the semiconductor sector to underperform the broader SPX and NDX markets.
• We suggest underweighting the SOXQ ETF, which tracks the Philadelphia Semiconductor Index, and being long either QQQ or SPY (tracks NDX and SPX, respectively).

Earnings May Drag on Equity Indices

As the Q1 earnings season opens, one notable thing about the S&P 500 (SPX) and NASDAQ 100 (NDX) is how earnings on a trailing and forward basis have essentially stalled over the past year (Charts 1-3). SPX earnings have flatlined. NDX earnings are trending down. And forward earnings for the Philadelphia Semiconductor Index (SOX) are down 15% since late last year after reported earnings soared in 2022 on supply-chain issues and chip shortages (Chart 4).

Yet the SPX and NDX have rallied 7.7% and 19%, respectively, since the year began, even with the Silicon Valley Bank crisis. SOX is off recent highs but still up 16%. The net result has been to lift forward price/earnings ratios near decade highs – apart from the bubbly Covid period when rates were low (Chart 4).

Street Talk on Q1 Earnings Is Bearish

Earnings reports and outlooks have been mostly solid so far this year. Yet many are warning of soft earnings and cautious outlooks for 2023. And we have seen no outright bullish forecasts.

Underweight Semiconductors

Given the generally negative sentiment and our view that inflation combined with high rates will slow the economy and weaken earnings growth, we see the NDX and particularly SOX as overvalued and due for a correction.

The semiconductor sector has rallied on robust 2022 earnings and more recently, excitement about ChatGPT AI technology that could spur higher demand for chips.

On the other hand, the chip shortage that bedevilled the auto sector during 2021-22 is easing – although not fully back to normal. Supply-chain problems that made it difficult to obtain necessary raw materials are also easing.

The consumer electronics sector, accounting for over 20% of semiconductor-related demand, is still in the doldrums. For example, PC shipments for Q1 2023 totalled 56.9mn units. That was down from 80.1mn units in Q1 2022 – no surprise there given the surge in at-home work and entertainment during the pandemic.

But the more telling numbers are 1Q 2018 and 1Q 2019, when shipments totalled 60.6mn and 59.2mn units, respectively. Several commentators see little likelihood of recovery until at least 2024 – as company outlooks indicate.

Excess inventory is still burdening key companies that serve the consumer electronics sector. For example, Micron Technology (MU) and Intel Corp. (INTC) are sporting inventory/sales ratios roughly double or more than normal levels (Chart 5).

These problems will not correct quickly, especially if a return to more normal demand levels is a year or more away.

Many semiconductor companies benefited last year from strong corporate CAPEX in networks, data analytics, cloud capacity, and automation to cope with scarce labour. During 1H 2022, CAPEX at SPX companies jumped by nearly a third but has since levelled off (Chart 6). Forecasts for 2023 are on order of a 6% increase over 2022 – or roughly in line with inflation. Given the huge jump in 2021-22, we would be unsurprised if CAPEX growth is near zero.

Bottomline, semiconductor companies that produce for the corporate market will not have the seller’s market that they enjoyed recently, with obvious implications for earnings growth.

Short SOXQ/Long QQQ or SPY

If we see a correction in NDX valuations in coming weeks or months, we expect the semiconductor sector will underperform. We suggest underweighting or shorting the SOX index via the SOXQ ETF and being long either QQQ or SPY (ETFs for NDX and SPX, respectively).

We are already short QQQ versus long SPY in our model portfolio.

Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)