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When Chips Are Down, They Rebound Slowly But Strongly

Long
TVC:SOX   PHLX SEMICONDUCTOR
When Chips are down; invest if you can and hedge if you must. Having soared in 2020 & 2021, semiconductor shares tanked brutally as tremors from geopolitics, sinking consumer confidence and bloated inventory struck.

Q4 overhang is dragging the industry down in the near term, which might have set a bearish outlook in the short-term, but times are changing. Structural forces and business cyclicality are now becoming robust tail winds for semiconductors, bringing a bullish outlook in the medium-to-long term for the sector.

Therefore, this case study argues that an asynchronous time spread in CME E-Mini PHLX Semiconductor Sector Futures ("CME Semiconductor Futures") could potentially deliver a 2.8x reward to risk ratio by first taking a short position in futures expiring in March 2023 followed by a path-dependant long position in futures expiring in September 2023.


INDUSTRY ON THE CUSP OF A SUPERCYCLE

Chips everywhere. Semiconductors are ubiquitous as products become sophisticated. Rapid growth of mobile devices, emergence of EVs, and rising cloud adoption have created endless demand for higher processing speeds and larger memory. Chipmakers have benefited from this trend.

Anticipated exponential growth in consumer durables, IoT, gaming, EVs, and AI/ML will translate into strong sustained demand for chips. Speaking at World Economic Forum, Microsoft CEO Satya Nadella asserted that AI would go mainstream not in years but in months.
Emergence of generative AI will form a fresh stream of demand for chips. EVs require twice as much chip content than traditional ones. Rising cloud usage will amplify demand from datacentres for graphics processing units (GPUs). In short, semiconductor industry is on the cusp of a demand super cycle.


DEMYSTIFYING THE SEMICONDUCTOR INDEX


The Philadelphia Semiconductor Index ("SOX") is a market capitalization-weighted index comprising of the top thirty (30) semiconductor firms listed in the US. Top names include Nvidia, TSMC, and ASML forming 48% of SOX. The top ten comprise 80% of the SOX.

SOX rallied 202% from its low in March 2020 to its high in November 2021. As monetary policy shifted from QE to QT, SOX plunged 46% in 2022 touching its lowest level in October 2022. Since then, it has bounced back 43%, outperforming both NASDAQ-100 and S&P 500 which are up merely 10% during the same period.


A CYCLICAL INDUSTRY



Semiconductors industry is inherently cyclical given the considerable time lapse between spotting fresh demand and matching them with new supply.

In a recent report, JP Morgan cited that semiconductor stocks are close to a cyclical bottom. Each time the industry hits a bottom, it recovers impressively. In one-year and three-years following a cyclical dip, shares in this sector spike 40% and 95% on average, respectively.

While short term demand looks bleak on waning consumer confidence, the USD 600-billion industry's long-term prospect looks resolutely bright.


LET THE AI WARS BEGIN

Revolutionary AI: ChatGPT made its debut in November. It sprinted to a million users in just five days. The excitement in generative AI is palpable. It will revolutionise content generation while delivering vast productivity gains in others.

Inflection ahead: AI is approaching an inflection point. Its usage is going mainstream. Expect tech giants to invest heavily to outcompete. If this marks the start of AI wars, the semiconductor firms that make AI work will harvest outsized profits.

Shovel makers hit jackpot: During the gold rush, it was the shovel makers that got rich more so than the diggers. In this AI gold rush, the shovel makers (i.e., the semiconductor stocks) are set to reap enormous gains.

Nvidia already shining: Nvidia is the market leader in GPUs whose parallel processing capabilities form the core for delivering AI. ChatGPT adoption alone could bring incremental revenues of up to USD 11 billion over the next year, Citigroup estimates.


TSMC & ASML well positioned: Nvidia GPU production depends on two firms - (a) the Taiwan Semiconductor Manufacturing Corporation (TSMC), and (b) ASML Holdings (ASML).


Berkshire stake in TSMC: TSMC recently announced stunning Q4 earnings. Its net sales grew 42.8% YoY, while its net profits & EPS were up 78% YoY contributing to an ROE of 26.4%. Little wonder that TSMC was one of Warren Buffett's recent investments where his firm acquired USD four billion of TSMC shares last November.

ASML dominance: Meanwhile ASML commands a monopoly on key tech (Extreme Ultraviolet Lithography or EUV). EUV is used in producing cutting-edge nano chips that AI requires. ASML is set to secure a windfall on rising AI adoption.




CHIPS ACT TO RESHORE PRODUCTION

Supply chain disruptions caused by the pandemic exposed the vulnerability of over-reliance on globalisation. Russia-Ukraine conflict caused adverse impact with Russia being a major supplier of Palladium and Ukraine being a key source of Neon gas.

To reduce over-reliance in a key industry, US last year legislated the CHIPS Act which is aimed at reshoring production on US soil supported by more than USD 150 billion of grants and tax incentives.


NO PAIN, NO GAIN IN A V-SHAPED PATH AHEAD

Supply ramped-up but a little too late: Clogged supply chains plus demand spike during the pandemic fuelled chip shortage. Ramped up production which always takes a long lead time arrived but at a time of pale consumer demand (PC demand down 28% YoY) late last year.
Frail consumer sentiment: Persistent inflation, recession fears, and uncertain outlook, meant lower consumer durable sales. This has slashed demand for semiconductors resulting in one of the largest inventory corrections in the industry. The sector is cooling faster and getting colder than expected. Firms face a tough market saddled with excess inventory compounded by frail end-markets except for automotives.



Downgraded chips: Intel reported a loss for Q4 last year and expects a weak first half this year with return to growth in second half. Earnings from other industry majors point to significant headwinds. Analysts have downgraded several chip stocks.

Fund flows in ETFs: Fund flows into and out of leveraged ETFs this year show investor activity is moving in tandem with these macro shifts. The Direxion Daily Semiconductor Bull 3x ETF (3 times long exposure to SOX) suffered net outflows of $341 million while the Direxion Daily Semiconductor Bear 3x ETF (3 times short exposure to SOX) gained net inflows of $1.1 billion.

Insiders are Net Sellers: Insider Activity among majors show that they have been net sellers over the last three months except for Qualcomm, Intel and Applied Materials.
Bullish Price Targets: In sharp contrast to this gloomy outlook, analysts covering the top stocks anticipate an average +15% price gain over the next 12-months.


TRADE SET-UP

This case study proposes a two-legged calendar spread as set out below.

Each CME Semiconductor Futures contract provides exposure to twenty-five (25) index points approximating to USD 75,000 in notional with required margin of USD 5,900.

TRADE LEG 1: A short position in the contract expiring in March 2023 will provide exposure to the short-term correction.


Entry: 2978
Target: 2571
Stop Loss: 3180
Profit At Target: $10,175
Loss At Stop: $5,050

TRADE LEG 2:
A long position in CME Semiconductor Futures expiring in September 2023 will provide exposure to recovery in the latter part of the year.



Entry: 2710
Target: 3718
Stop Loss: 2410
Profit At Target: $25,200
Loss At Stop: $7,500
Aggregate Reward-Risk Ratio: 2.8x


MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com/gopro/

DISCLAIMER
Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.
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Comment:
Berkshire Hathaway announced the sale of 86% of their stake in TSMC for a profit according to a regulatory filing. They instead chose to boost their holdings in Apple. This led depository shares of TSMC to decline 4% after-hours on Tuesday while shares in Taiwan fell 3.3% on market open.
Comment:
With the March Futures expiry on 15th March 2023, the first leg of the setup is closed at a closing price of 2977. The entry for this leg was 2978 which means that the leg closed at PnL of ~0.

The next stage of the trade was a long position on the PHLX Semiconductor June Futures which was entered on 15th March 2023, at an entry level of 3006.

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