Semiconductor Bull Run: more steam ahead, but take cautionSome industries are notoriously cyclical. Semiconductor is a prime example. It swings to the extreme on both bullish and bearish sides. While the industry is in a bull run, investors can still participate in its rise but with caution.
The PHLX Semiconductor Index (“SOX”) is a modified market-cap weighted index. It is composed of semiconductor firms involved in the design, production, and distribution.
This paper dives into the factor’s driving SOX performance. It expounds on the cyclical nature of the industry, and its outlook fuelled by AI frenzy.
Finally, this note posits a hypothetical spread trade to gain from index outperformance relative to the broader market. The spread has been found to be more resilient that an outright position in SOX ETF or futures.
UBIQUITOUS AI
AI here. AI there. AI everywhere. AI by far is the single most driver of SOX outperformance. VANTAGE:NVIDIA , the AI darling commands ~10% of the SOX. Other AI majors include Broadcom (9.3% weight) and chip equipment maker ASML (4.5% weight).
The strongest profit harvester of AI boost is Nvidia. Expectedly, it has strongly outperformed SOX. AI-driven demand is evident in its financials. In 2023, its revenues rose by 125% YoY while Net income spiked by a jaw-dropping 580%.
Consistent earnings beat-and-raise has propelled its stock prices to more than 500% gain since the start of 2023. Outsized impact of Nvidia’s earnings is from AI data centre sales.
AI NOW, AND MORE IN THE FUTURE.
Nvidia is clearly benefiting in the near-term. Other majors are ramping up their AI offerings. Notable among them are NASDAQ:AMD (9.8% weight in SOX), VANTAGE:INTEL (6.75%), and $Qualcomm (7.5%).
These firms are yet to witness a major AI driven boost. 2023 data centre revenue for these firms remained underwhelming relative to AI winners such as Nvidia and Broadcom.
Broadcom’s AI driven demand for its networking solutions led to revenue of USD 2.3 billion in Q1 2024 which represents a four-fold increase YoY, reported MarketWatch. For 2024, they forecast AI-driven sales to reach USD 10 billion.
Data Source: TradingView
Meanwhile, Intel, AMD, and Qualcomm are in the process of launching their own AI offerings.
Qualcomm’s updated Snapdragon X Elite chips runs on ARM architecture. These offer enhanced AI capabilities, energy efficiency & performance compared to current platforms from Intel and AMD.
AMD updated its guidance for AI graphics offerings to USD 3.5 billion this year (v/s two billion previously). Although, below expectations, the raised outlook signals that sales ramp up is yet to materialize.
Intel is planning to launch AI PCs. Uniquely, in such PCs, AI inference will be localized on the user’s machines rather than on the cloud. Like Qualcomm, Intel’s AI PCs may revive its faltering PC sales.
NEXT TO AI, REBOUND IN MOBILE PHONE SALES IS HELPING THE INDUSTRY
Beyond AI driven demand, rebound in smartphone sales highlighted by Counterpoint Research has helped change the fortunes of this industry. Final quarter of last year marked the first quarter of annual growth after 7 straight quarters of declining sales volume as per their report .
Smartphone sales rebound benefits not just mobile chip makers like Qualcomm but also manufacturing service providers like TSMC.
SEMICONDUCTOR INDUSTRY IS NOTORIOUSLY CYCLICAL. FORTUNATELY, BULL CYCLE FOR NOW.
Semiconductor industry is prone to cyclicality. It is impacted by idiosyncratic consumption patterns. As a result, industry runs into large inventory buildups resulting in gluts for outdated products and shortages for new ones. Due to the rapid innovation rate, production sizing is hard. Even harder is for manufacturing output to adjust to shifting demand dynamics.
Cyclicality is on over-drive these few years. Pandemic disrupted chip production while demand remained robust. Subsequent shortage impacted not just semiconductor firms but also various other industries reliant on chips.
Manufacturers ramped up production to meet high demand. Soaring inflation drove central banks to raise interest rates. This caused consumer spending, especially on discretionary electronic items to nose-dive. This dynamic rapidly drove chip inventories from a severe shortage to demand crushing glut. What followed was painful mark-downs and profit crushing unit sale declines.
Cyclicality is ingrained in this industry due to its consumption, innovation, and growth cycles. As an example, consider VANTAGE:INTEL ’s revenue and profit. VANTAGE:INTEL derives majority of its revenue (54% in 2023) from its Client Computing division comprising of consumer-focused processors.
The impact of seasonality is also palpable in the net income of memory manufacturer $Micron.
HYPOTHETICAL TRADE SETUP
Robust financial performance is evident for some stocks within SOX. Other names within SOX are yet to reap the harvest of top-line and bottom-line growth from AI.
Notwithstanding, SOX continues to rise. It is up +100% relative to the start of 2023 when AI-driven hype came to the fore. Over exuberance and risks of a bubble are clear. A macro slowdown or industry-specific setback could drive a sharp reversal in SOX.
Instead of an outright position in SOX ETF or Futures, spreads between SOX and other equity indices shows that SOX/S&P 500 spread makes for a compelling hypothetical trade setup.
SOX/S&P 500 spread offers improved upside relative to SOX/Nasdaq-100 and SOX/XLK spread. It also offers resilient performance during sharp corrections (August to November 2023).
The SOX/S&P 500 spread is 36% higher since the start of 2023 and close to its highest level seen during 1995 and 2000. For reference, the SOX index is up 80% from 2023 and soaring far above previous all-time-highs. This implies that much of the recent run-up in SOX has come alongside a broader rally in the S&P 500. SOX outperformance is likely to continue while SOX tailwinds remain intact.
A hypothetical spread trade comprising of two lots of long CME E-Mini PHLX Semiconductor Sector Futures (“SOX Futures”) and short one lot of CME E-Mini S&P 500 Futures can offer a reward to risk ratio of 1.5x. Two contracts of SOX Futures are required to match the notional for one contract of E-Mini S&P 500 futures.
• Entry: 0.927
• Target: 0.97275
• Stop Loss: 0.897
• Profit at Target: USD 11,783 (+4.9%)
• Loss at Stop: - USD 7,893 (-3.3%)
• Reward to Risk: 1.5x
MARKET DATA
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