Why I'm Bearish on the Chip Equipment Cycle

I want to alert readers to some recent news out of Taiwan Semiconductor (TSM) and United Microelectronics (UMC), the two largest semiconductor outsource contractors in the world. Both companies indicate they are going to significantly cut capex for chip equipment in 2008.

I also refer you to some notes on a panel discussion (below) that took place in late May, 2007 with chip analysts Dan Niles, James Covello, and Joe Osha. These three men are well-regarded in the semiconductor industry and have many years experience following chip equip companies. For all three analysts to be so bearish so early is notbable. We are in the midst of raging bull market, but underneath the surface, is there trouble brewing ahead?

There has been a 17-19% negative-divergence between the Nasdaq and the SOXX (Phil Semiconductor index) since Sept. 10th, and it's been most pronounced since October 1st. I've looked back through 15 years of charts and could not find a negative divergence between the chips and the Nasdaq so pronounced in such a short amount of time.

This divergence leads me to two conclusions (only one's gonna happen): chip stocks could rally shortly (as in this week) into the end of the year to catch up with the Nasdaq; or the Nasdaq could correct to close this negative divergence, and the market might actually drop into November and December, typically the best investing months of the year. The SOXX has never bottomed when the Nasdaq was soaring. Never.

The kind of volatility we have seen recently reminds me of the same kind of stuff that went on in August at the bottom. Could it be we're near a top? Ten of the last eighteen trading days have seen market values fluctuate (up or down) 2%+/- a day. The tops from July 2006 on the Nasdaq go right through the recent high of 2860. The put/call ratio for the Kulicke and Soffa Industries (KLIC) options I am purchasing (Jan 09, 7.5 strike price) to protect my investment in KLIC is 10/1; very bearish.

I also have a personal barometer that seems to do me well. When I am not having any luck at long positions it's telling me that the tide has begun to turn and I am fighting it. Anyone else feel that way in the midst of all this bubbly effluvent tech and Chinese and solar etc froth? When I look for good buyable charts in names that I want to pick up, I'm finding only parabolas as far as the eye can see.

The other caveat to this discussion is the Presidential Cycle (which we are currently in). 2008 is very reminiscent of the Long Term Capital bust of 1998. Although the LTC bust affected financial stocks severely, the Nasdaq went on a huge tear after the dust settled. If that's the case here, then the Nasdaq could be on the verge of correcting, or, conversely, on the verge of going parabolic with its Chinese friends too. This is an interesting conundrum. A top is when EVERYONE finally turns bullish and I am not sure we're there yet, although I've heard there's a daycare problem in Shanghai because so many mothers are playing the market during the day.

Kulicke and Soffa Industries

The following is a discussion directed at technical analysis. Feel free to pipe in with comments. In an effort to "pick up" as many low points of confirmation as possible in an upward ascending channel line for a chart of KLIC (I count 7 points of confirmation), the long term trend line moves from the high $2.00s (in 2002) through $7.70 (2007).

These are my observations. Since KLIC has already broken below 7.70 - and now gone 5% further down - I see meaningful support at 6.50. If the CEO, Scott Kullicke, uses any kind of "a little more order softness ahead" language in his upcoming remarks at the CC on November 15th, we could get there quickly. The thing is, KLIC goes up when he says that visibility is still poor but looks to improve. Are we there yet? I don't think so.

The fly in the ointment is this - might the chip sector also be a leading tech indicator - because it ALWAYS bottoms with the rest of the market? Uh-oh. The Nasdaq is just a few points from its 7 year HIGHS! Take a look at every bottom for KLIC from times past and you will see a tanking Nasdaq right there along side it. So...in answer to the query, "Are we there yet?" (from a technical standpoint, especially with reference to a corresponding low in the Nasdaq) the answer is again, most decidely NO.

Scary, huh?

So what kind of drop in KLIC could we expect with a "surprise" (no one's counting on this) drop of (-300) to (-400) points in the Nasdaq (from today's 2,810)? That's about a 10% correction. Throw in a tanking Shanghai index and it could be more.

I think KLIC would settle somewhere between $6.00 to $6.50. The semiconductor ETF (SMH) looks like it's set up a perfect head and shoulders top, with a drop on the right side ready to go down to the July 2006 low of 29. A corresponding drop would put KLIC at its July 2006 low of 6.50.

So $6.50 gets my vote from a technical standpoint - by comparing past KLIC cycles with this one and correlating those to lows on the Nasdaq and the SMH. $6.50 would be a 48% retraction from the recent high, or a mid-range correction for KLIC within its long term uptrend based on its much-improved fundamentals ($) this time around. Quite simply put, the company is very profitable at an approaching low in the cycle. I don't think this has happened for decades. As a matter of fact, if the company comes out of this cycle-bottom supremely healthy, we could have a very strong KLIC ready to soar in 2008-09. I always felt it was a shame - considering they owned 80% of the bonder market and made the best equipment - to not share in the financial strength of other chip equip stocks.

Just seven years ago this industry was on the ropes - kinda like the financials and real estate are now. As a matter of fact, it's instructive to look at the percentage growth of the trajectory of SPX financials: 7% of the SPX in 1990, 13% in '95, 17% in 2000, 20% today. The same kind of increased popularity followed technology stocks from the early 90s - where they were barely a blip in the SPX - to the hundreds of tech and Internet stocks that proliferated during the 90s and expired after the dotcom bust of 2000-01.

I read that Bill Miller, the veteran manager of Legg Mason Value Trust [LMVTX], wrote a letter to his shareholders over the weekend. In the letter he said:

Fear dominates the pricing of housing stocks, of mortgage-related securities, of financials, and of many consumer stocks. The greatest gains over the next five years will be made in those securities people are panicked about today.

Sound doggone dotcom familiar? When was the last time that the CEOs of the largest brokerages and banks in the world got canned in the same week? This is an unprecedented time to be buying financials. Let's just hope we pick the right ones.

Lastly, with reference to KLIC, who wouldn't back up the truck if they could buy KLIC between $5 and $6? Having said that, I have never bought KLIC at the "right time" so to speak. I find its buy point elusive. Even after all these years, I have always been early, always regretful at the start. I have always been scared when I added to it too. And I've always had a drawdown before it turned profitable.

I don't feel any of that kind of buying atmosphere surrounding the chip stocks (yet), do you? Which leads me to believe in my ruminations there's more to the downside yet. Investors who are able to pick up KLIC in a range between $5 to $7.00 are looking at a great investment (+50 to 75%) at the next semiconductor cycle top. You might ask me, "If this is so, why don't more investors do this?" Answer: "Almost no one has the patience to wait."

Notes from: "Panel Of Analysts Bearish On The Chip Gear Industry "

Author: James Detar

Section: Internet & Technology, Investors Business Daily

Date: 5/25/2007

"I think we're heading to the worst semiconductor equipment downturn - perhaps ever," said James Covello, a Goldman Sachs analyst. "We're starting to see the first signs of that." ....

The comments of Covello at the Churchill Club's 11th Annual Semiconductor Forecast event were the most incendiary, but the other speakers shared similar sentiments for the notoriously boom-and-bust chip and chip gear industries.

[...]

In the past 20 years there have been four major downturns in the equipment sector, Covello said, each lasting about two years. He expects a fifth major downturn, this year and next.

[...]

He is betting on a steep fall.

He said he would short the shares of, "any semiconductor equipment company. Novellus is No. 1 (among stocks he would short), followed by Applied Materials and Lam Research, in that order."

(Joe) Osha said most people don't yet realize just how bad the impending chip equipment slowdown will be.

"If you looked at the overall consensus of analysts today, it would still show equipment (stocks as a group) will be up a little bit in 2007. That's laughable," Osha said...

Niles agreed with Osha and Covello that things are getting tough in the equipment market.

"The equipment guys get 50% of their business from memory companies," Niles said. "There will be cutbacks in capital spending."

He also advises to keep an eye on Intel, which is focused on cutting expenses to compete with rival Advanced Micro Devices. If Intel - the world's biggest chipmaker - cuts capital spending, that could have a ripple effect in the equipment sector, he said.

Comments

[teddy:]

"The SOXX has never bottomed when the Nasdaq was soaring. Never. "

Try may-july 98. Starting 5 may the sox lost 19% by 20 july. the nasdaq rose 18%.

the soxx never caught the nasdaq from there until the peak of the boom in early 2000.

never say never

2007 Nov 21 10:05 AM

[Angelo Bert...:]

Great November call! Classic head and shoulders.
The question now is, will the SOX hold at longterm support of around 375 which is not too far from here, or are we destined to probe deeper? Many have said that the 3-year sideways action in the semis was a bullish indicator. How could it be when there was a bull market in everything else?

2007 Nov 23 05:39 AM