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Chips’ failed rally leaves them historically cheap

Chips shares took a beating last year. A halfhearted rebound in the final months staved off the second-worst annual performance on record. But even a huge reduction in earnings expectations doesn’t change the fact that the sector is now trading around historic lows, leaving investors trying to figure out whether to wade back in.

The 30-member Philadelphia Semiconductor Index (SOX) dropped 36% in 2022, the biggest decline since 2008. If not for a 28% rebound, which was reversed in recent weeks, the gauge may have even surpassed the 48% drop back then. The fact that the rally fizzled out raises the question of how cheap they’ll get.

What’s given investors moments of fleeting hope is the belief that the semiconductor industry is in the midst of a once-in-a-generation revival. A shortage spurred by the Covid-19 pandemic showed the world what executives had already known: Chips are needed in everything from cars to warheads, and that hunger will only grow.

Chips’ failed rally leaves them historically cheapThe US’s ongoing strategy to cut China off from leading-edge technology has spurred Beijing to double down on its own plans to build a self-sufficient industry. Meanwhile, politicians in Washington, Tokyo and Brussels have been offering sweeteners to get key players to set up shop. The most sought-after, Taiwan Semiconductor Manufacturing Co., announced expansions in the US and Japan over the past couple of years while remaining tight-lipped on any plans for Europe. TSMC is also pushing ahead with building more at home, recently unveiling its latest facility in southern Taiwan.

This government-subsidised capacity expansion combined with a slowing global economy, rising interest rates, and the invasion of Ukraine to make sell-side analysts more cautious about the sector’s profits for the next few years. On average, 24-month forward earnings estimates for the SOX have been trimmed by 17% since a peak in the first quarter of 2022. That’s the largest re-rating of chip stocks since 2010.

Investors have been selling in lockstep with these new expectations, bringing the price-to-earnings ratio for the SOX down to 18.2 times, according to weekly data compiled by Bloomberg. That figure has been at or below 19 for less than 20% of the last 20 years, and sat above 22 for 63% of that period.

Only history will be able to tell us whether this current era — marked by war, escalating geopolitical tension and an explosion in next technologies — is a real outlier, or just part of the broader sweep of technological progress. For sure, chip stocks are rarely this cheap. Investors will need to decide whether such a big drop in outlook for semiconductor earnings is justified and will continue, or if all this gloom is overblown and makes for a rare opportunity to buy.

After all, if political and business leaders are right, semiconductors will be a precious resource for years to come. Making chip manufacturers the most important companies on the planet. Bloomberg

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