Time Warp

The cycles of the semiconductor industry and Wall Street reside in different time zones. This polar-opposite existence is causing great angst for those who have their financial well-being linked to semiconductor issues. This past summer, one chip equipment CEO asked me, "The troops are working hard, but they are not happy with the way our stock is acting! What do we have to do to get share prices moving?" I tried really hard to muffle the sarcasm when I answered, "Share prices will start moving up when we enter another downturn." As you can imagine, my comment was answered with a frown and furrowed brow.

If you study the actions of the buy-side investors — mutual funds and hedge funds — you will find that they are focused on "predicting" cyclical inflection points, not the length of the cycle. These investors do not have the patience to wait for cycles to turn. They believe they must anticipate. In doing so, they are willing to disconnect or reconnect their portfolios from chip-related issues well before there is a visible change in business trends. One could say that today's stock market has become a case study of behavioral finance, dominated by the buy side. Generally, bets are made based on pendulum swings in sentiment. This behavior is evident in capital equipment, given its history of high valuations, its speculative nature, and extreme beta.

This strategy took hold long before sell-side analysts — the analysts that you find quoted in news stories — decided that this was where the world was going. The sell side has moved more aggressively toward this line of thinking; you can see it in a number of the reports today

In essence, the buy side is the group that moves the stocks. Monitoring the movements of the large mutual funds and hedge funds should be a focal item.

On sentiment: We are starting to see some change. During the past few weeks, reports from Wall Street seem to be moving toward the premise that chip stocks will not go much lower, and that some accumulation is warranted. Not everyone agrees. There are still some die-hard bears that believe this business cycle is over and that next year will bring about some very rough sledding.

I believe this subtle change in sentiment is the very reason why semiconductor and semiconductor equipment share prices are holding up in the face of all the bad news. The number of bad news pre-announcements this quarter is smashing records. If my "time zone" theory is correct, bad news means good things for stock prices. As profound as it sounds, it is probably time to start loading the boat!

Before I go, allow me to talk about the long-term investment outlook. I think a wide-angle view (more than three years) of the investment action shows that equity markets have been arbitrating the semiconductor group's excessive valuation, taking out the beta-premium, and slowly moving the sector toward a more rational valuation point. Is it an end point? No. I think it is best to call it an "industrial tech valuation" point — a point that implies less cyclical growth. This valuation point might even fall neatly in line with the long-term, secular growth rate of the industry.

Now, making this a blanket call is foolish, because individual companies hold specific strengths and weaknesses — factors that Wall Street will validate given an appropriate amount of time. Clearly there are going to be those that outperform industry averages. In general, though, the painful process of revaluation is something that will probably continue for many. Keep this in mind as we ride through the short-term cycles.