The Chips Are Down

Tuesday’s semiconductor equipment book-to-bill ratio was either a bottom in fundamentals for the sector, or a sign of how tough this recovery’s going to be.

The book-to-bill ratio came in at 0.42 for April, meaning that for every $100 in product shipped last month, only $42 in new orders were received. That is one heck of a bad month, much worse than the 0.60 reading analysts were expecting. It was the lowest reading in at least a decade, bad enough to prompt the trade group that published the report, Semiconductor Equipment and Materials International (SEMI), to say that “the severity and depth of this industry correction is unprecedented.”

The report was bad enough to prompt one of the few sell-offs on negative fundamental news since the April 4 bottom. Think yesterday’s sell-off in the Nasdaq was about the defection of Republican Senator James Jeffords that threatens to tilt control of the Senate to the Democrats? Think again. Jeffords’ defection affects tobacco, drug and energy stocks and the like. On a day that the Nasdaq dropped 3%, the Philadelphia Semiconductor Index fell 5%.

The economically-sensitive semis tend to lead the Nasdaq both to the upside and the downside, which means yesterday’s sell-off probably wasn’t a one-day affair. We’ll see how the semis recover today. The good news is that investors’ fear spikes at the slightest down move in the market. The CBOE put-call ratio jumped from .47 to .73 in just two days (readings of 1.0 or higher typically accompany significant bottoms), which means that there are still plenty of shorts to fuel further stock market gains.

But the news so far in May hasn’t been good for semiconductor companies. Communications chip companies in particular have been inundated with rumors of cancelled orders.

And valuations in the sector are historically very high. Applied Materials and Intel are trading at 2-3 times the valuations they have historically bottomed at, and earnings are falling 60%-90%.

Semiconductor stocks are notoriously cyclical, capable of producing bad years even in the midst of strong years for the economy. Like clockwork, every few years the industry goes through a cycle of boom and bust fueled by overcapacity and overinvestment.

Interestingly, according to the valuation service Trouncing the Dow, Intel is the second most expensive stock among the 30 Dow Industrials right now, topped only by AT&T’s abysmal fundamentals. But other pricey Dow stocks include International Paper and General Motors , deeply cyclical issues that have been hit hard by the economic slowdown. An old adage is that you buy cyclical issues when their fundamentals are at their worst, and sell them when they’re at their best. Perhaps the same adage applies to the semiconductor sector.

The stock market tends to lead the economy by 6-9 months, and right now the market is predicting an economic recovery by the end of the year. Investors bid up tech stocks at the slightest hint that companies may be prying open their capital investment wallets. Cisco Systems rose Monday and Tuesday on suggestions of a modest uptick in its optical business and rumors that some big orders may finally ship this quarter.

But so far this rally has been about hope, hope that the most aggressive Fed easing cycle in history can pull the economy out of the doldrums. But Fed easing might not be the cure-all for the overinvestment in the semiconductor equipment sector. Watch the equipment book-to-bill ratio this time next month for clues. Even a slight uptick would be a welcome sign.

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