Ah, the beloved headline-worthy semiconductor topic. I’ll spare you the chip jokes and just state, for the record, that my favorite chips are chili cheese Fritos.
It’s been a tough year for semiconductor stocks, with the Philadelphia Semiconductor Index down 44.3% YTD (the widely-discussed VanEck Semiconductor ETF, ticker SMH, is also down 43.2% YTD).
What’s interesting about semis is that their price action as a group can be used for more than simply talking about where the worst pain is in Tech stocks. They’ve come to be regarded as an indicator of stock market direction and the health of business conditions. The way our economy has changed over the last century brought semis into the forefront, but they weren’t always the bellwether of choice for investors.
The Lost Art of Transports
Back in the day—and I mean really far back, 1901 to be exact—a theory was constructed by Charles Dow about the behavior of the Dow Jones Transportation Average (“Transports”) in relation to the Dow Jones Industrial Average (“The Dow”) and used as a rule for identifying buy and sell signals in the stock market. The nuts and bolts of this theory were also used to analyze business conditions in the U.S. for many years to come.
The intricate details of how these signals are determined are beyond the scope of this piece. To simplify, the idea was that Transports and The Dow were good representations of not only stock market strength and behavior, but were the main drivers of U.S. innovation and growth over the decades that followed.
That was true during the age of the railroad and when our economy was heavily dependent on goods creation. Today, the U.S. economy is driven primarily by services. The Industrial Revolution has been replaced by one of technology and robotics, which has automated much of our output. The chart below illustrates the changes in shares of GDP over time. Manufacturing (closely tied to industrial and transportation stocks) has shrunk, and services categories—including those that account for technology—have grown considerably.
Needless to say, transportation stocks don’t carry the same weight as business signals as they used to. In fact, the weight of Transportation stocks in the S&P 500 has been more or less flat since 1990, at 1-2%, while the weight of Technology has gone from 6% in 1990 to 26% today.
They’re in everything. The computer I’m typing this on, the phone that’s sitting next to me, the car that got me to the office today, and even the electronics in the kitchen that kept our iced coffee cold and heated up our oatmeal this morning. They touch nearly every sector of the economy in some way, and are now thought of as a more modern tool for determining business conditions and stock market sentiment.
So what does this year’s price action in semis suggest? Not surprisingly, that economic activity has slowed quite dramatically and we’ve been faced with multiple external factors, such as trade sanctions and supply chain issues.
We can also see from the chart below how much more volatile the earnings patterns of semiconductors are than the tech sector overall. Investing in semiconductors isn’t for the faint of heart, but it can reap big rewards for patient and prudent investors.
On a pure earnings basis, semis have felt more pain than technology broadly, and if we do enter a recession in the next 12 months, I would expect further downside in earnings and prices ahead of the economic downturn.
We also need to evaluate investment opportunities on a valuation basis, and in many cases, the lower the better for buying opportunities (in some cases, valuations are low for a reason and indicate fundamental issues). The current forward price-to-earnings (P/E) multiple on semiconductors is 13.8x, which is below the Tech sector P/E of 18.3x and below the S&P Index P/E of 15.4x.
One could argue that semiconductors are attractively priced at these levels, and I would have a hard time disagreeing with that. One could also argue that we are nearing extreme levels, or “oversold” conditions, given how much semis have drawn down this year. That’s where I would pause and say “nearing, but not yet.”
The typical formula goes like this: markets fall first, earnings fall next, the economy falls last. The market has certainly fallen, but not quite enough yet for me to confidently say we’ve priced in all the risks to come. As we embark upon Q3 earnings season, and draw closer to mid-term elections, there could be more downside in the stock market and semiconductor stocks over the next few weeks. But we’re getting closer to a point where sentiment could feel overly bearish and hit more extreme drawdown levels than the prior lows of this year.
Timing the market is impossible, and hitting price targets on the head is also impossible (or at best, a function of luck). But we can use guideposts, and one of mine is if the S&P breaks below 3500 and approaches a range of 3300-3400, I would be more comfortable with how much risk we are pricing in. An S&P at 3357 (to be exact) would be -30% from the January 2022 highs. That’s nearing the ballpark of a drawdown I would expect to see in a recessionary environment. When fear and selling starts to hit extreme levels, opportunities tend to increase. Semiconductor stocks are likely to feel the pain in that scenario, and would become more attractive from a valuation perspective, a market cycle perspective, and as a long-term growth opportunity.
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