Opportunity Ahead In Semiconductors

by: Clif Droke

Chip makers were among the hardest hit by last month's decline.

Yet, the earnings outlook for many semiconductor companies is bullish.

Trade fears are overdone, and the semis will shake off these concerns.

The last few weeks have been rough ones for the chip makers. Several high-profile semiconductor stocks took big earnings-related hits in May, and the industry is lagging the S&P 500 Index (SPX). Yet, many semiconductor stocks still have a lot going for them, both from a technical and fundamental perspective. In this report, we'll examine some of the bargains to be found among the semis.

After starting out this year on a high note, many semiconductor stocks have suffered substantial losses over the past month. While the benchmark iShares PHLX Semiconductor Index (SOX) rallied 35% in the first four months 2019, the SOX plunged almost 20% in May, with many big-name chip makers having lost even more than that. By contrast, the S&P 500 Index (SPX) was down only 7% in May. Disappointing earnings and guidance from many chip makers were one of the reasons for the semiconductor sector slump.

The outlook for the chip makers also deteriorated after the April-May sell-off in many big semiconductor names. After the U.S. raised tariffs on $200 billion of Chinese exports in May, concerns have only increased among investors who worry about the potential impact that an escalating trade war could have on the industry.

A case in point is Intel Corp. (INTC). In late April, Intel released below-consensus earnings guidance for the rest of 2019 and warned investors that its plans to migrate away from PC chips to the more potentially profitable markets for memory and data centers would likely weigh on profit margins in the coming three years. INTC shares were subsequently punished with a 27% decline over the next four weeks. The stock has made a bottoming attempt since then, but investors remain uncertain of the company's intermediate-term prospects.

Intel Corp.

Source: BigCharts

Then, there are the restrictions placed on microchip sales to China's Huawei Technologies. Last month, the U.S. Commerce Department action required American suppliers of tech manufacturer Huawei to obtain U.S. government permission to do business with the company. Some investors view this is a sizable risk factor for the U.S. semiconductor sector. Yet, a quick glance at the earnings expectations for the semiconductor stocks suggests that industry analysts have already discounted the trade restrictions and don't view them as a serious threat to the industry's growth.

Below is a chart showing the forward earnings trend for the S&P 500 Information Technology sector, which includes the semiconductors. As you can see, forward earnings remain in a positive trend as analysts apparently expect the info tech sector to overcome the obstacles facing it from the Huawei restrictions and the U.S.-China trade war. The fundamental backdrop for the sector also suggests that investors are overreacting to disappointing guidance recently provided by some semiconductor companies.

S&P 500 Information Technology Sector Forward Earnings Source: Yardeni Research

Earnings and revenues trends for several leading semiconductor companies also support an optimistic intermediate-term (3-9 month) outlook for the sector. While shares of leading chip maker Intel remain subdued after the sell-off earlier this spring, earnings projections over the next two quarters support an optimistic outlook. Shown below is the quarterly EPS estimate trend for Intel through Q3 2019.

Source: Reuters

Another example of an attractive semiconductor stock, both from a technical and a fundamental perspective, is Lattice Semiconductor Corp. (LSCC). Lattice boasts an impressively rising trend in its earnings per share estimates through Q3 2019, which can be seen below. Lattice is also among the semiconductor stocks in a relative strength position versus the S&P 500 Index (SPX).

Source: Reuters

Yet another positive estimated EPS trend can be seen in the graph below for Teradyne Inc. (TER), which develops semiconductor test solutions. I believe that once the latest wave of fear over trade tariffs has dissipated, investors will be forced to recognize the many attractively valued and technically oversold bargains among the chip stocks.

Source: Reuters

Earnings multiples for many chip companies are quite compelling and also argue in favor of the semiconductor stocks being attractive buy candidates for when the latest broad market correction has bottomed. I've noticed that quite a few of the 50 most actively traded semiconductor stocks on both the NYSE and the Nasdaq sport P/E ratios of 10 or less. The beaten-down semis are likely to be among the biggest beneficiaries of the next rally phase which I anticipate will begin later this month. I recommend that the best way to take advantage of the next rally in the semiconductors is the Invesco Dynamic Semiconductors ETF (PSI), which is a fairly low-risk way of participating in an industry-wide rally. For now, though, investors should keep their powder dry and wait for the next confirmed bottom and re-entry signal.

Speaking of entry signals, here's what the 4-week new highs-new lows momentum indicator looks like for the 50 most actively traded semiconductor stocks. This indicator is my favorite tool for evaluating the near-term path of least resistance for the semiconductor stock group. As you can see here, the semis are still subject to a weak internal momentum current, and while I anticipate a strong reversal soon, a buy signal isn't currently supported by this indicator. But once this indicator reverses its decline and we get a confirmed buy, the rally should be a powerful one based on the amount of short interest that has built up in the tech sector in recent weeks. Retail investors' bearish expectations for the semiconductors are another reason for expecting a market-beating performance from this industry, from a contrarian perspective.

Source: Nasdaq

As tempting as it may be to jump in right now and starting buying the beaten-down semiconductor stocks, another factor which argues in favor of waiting is the still-elevated number of stocks making new 52-week lows on the Nasdaq. Since most semis trade on the Nasdaq exchange, it stands to reason that internal weakness in the broad Nasdaq can influence the semiconductor stocks. As of this writing on June 6, the new 52-week lows on the Nasdaq are still above 100 and are outpacing the new highs. This strongly suggests that internal selling pressure is still a problem in the tech sector, and it needs to diminish before we can safely launch a new buying campaign among the chip stocks.

It's clear right now that tech investors are being unduly influenced by news headlines which pertain to the global trade outlook. Fear is a temporary emotion, however, and participants can expect to see the recent fear wave dissipating soon. When it does, and when there has been a corresponding decline in the number of Nasdaq-listed stocks making new 52-week lows, there will be an excellent buying opportunity which I anticipate will occur by later this month. For now, though, a defensive stance is still justified as the sellers still have control over the stock market's immediate-term (1-4 week) trend.

On a strategic note, my trading position in my favorite market-tracking ETF, the Invesco S&P 500 Quality ETF (SPHQ), was stopped out on May 10 after the ETF fell under the $31.70 level on an intraday basis, triggering my stop loss. This put me back in a cash position in my short-term trading portfolio. Meanwhile, investors can maintain longer-term positions in fundamentally sound stocks in the top-performing real estate and utilities sectors as we wait for the latest short-term market weakness to dissipate.

Disclosure: I am/we are long GDX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.