Chip stocks made a breathtaking comeback in the first quarter, but don’t be surprised if the rally gives up some of its gains, investors warn. The semiconductor sector on Friday wrapped up its best quarter since 2020 as investors rotated back into the downtrodden industry, with names like Nvidia notching its best quarterly stretch since 2001. So far this year, the iShares Semiconductor ETF has gained about 22%. Many semi stocks outperformed in the first quarter despite a weakening macro backdrop, as hordes of investors flocked to the sector – and broader tech – in search of safety amid the chaos rattling banking stocks . Semiconductors underpin virtually every technological advancement on the planet, from electric vehicles to automation, computers and medical equipment. The sector took a hefty beating in recent years as Covid-19 lockdowns constrained supply chains, and consumer spending on products like PCs and gaming slowed in the wake of sticky inflation cutting into discretionary budgets. NVDA YTD mountain Nvidia shares so far this year Despite their cyclical nature and close correlation to demand and the state of the economy, these names bounced to start the year as one of the biggest global economies reopened, bond yields declined , and investors bet that the sector’s incredible pain was nearing a bottom. The rise in shares also coincided with the hope that an end to the Federal Reserve’s hiking cycle may be just around the corner. Some investors also bet big on the sector’s role in the AI “iPhone moment” overtaking Wall Street, with these tailwinds lifting companies tied to graphics processing units such as Nvidia and Advanced Micro Devices , adding 90% and and 51.3%, respectively, over the three-month period. But the sector’s outlook is murky as it enters a seasonally slow period, and the macro picture appears to be deteriorating . Bank of America recently said April tends to be a “sluggish month” for semis, while the second quarter is often the least productive. Meanwhile, research and consulting firm Gartner predicts the industry’s global revenue will fall 6.5% this year . “It’s a mixed picture, but likely a challenging one in light of how much stocks are up, with the most immediate manifestation of the inventory excesses showing up in memory volumes,” wrote Morgan Stanley’s Joseph Moore in a note to clients this month. “We expect every sector to show some degree of inventory correction in the next 12-18 months.” The case for fading the semiconductor rally A potential economic slowdown is one of the major reasons to expect a pullback, according to many investors. In this camp is SoFi’s Liz Young. She told CNBC’s “Halftime Report” on Monday that it’s time to sell. “I think they got way over extended,” Young said. “If tech does go through a pullback, semis get hit harder than other industry groups.” The recent tear in semiconductor stocks brings the sector into overbought territory versus non-financial cyclicals, said Credit Suisse’s Andrew Garthwaite in a recent note. If history is any guide, that means these companies should underperform in the next three to nine months. SOXX YTD mountain The iShares semiconductor ETF so far in 2023 Of the five previous instances in which the sector hit overbought territory, semis underperformed by 12% on average within the proceeding nine months, Garthwaite said. He added that the group trades expensive on a price-to-earnings, price-to-book and price-to-sales basis. Still, there is another way to look at the move. The semi bounce may signal fundamentals for the sector are bottoming out. Angelo Zino, a senior industry analyst at CFRA Research, said the sector typically rallies four to six months before a bottom kicks in. “Now, the question is what kind of recovery do we get as the year progresses and that’s a lot more difficult to kind of price in, especially in a more choppy, challenging macro landscape,” with uncertainty lingering over the health of the consumer, he said. Finding opportunities in a ‘mixed bag’ Searching for stocks in this environment is no easy feat given the surge in share prices, multiple expansion and the lingering economic questions. Satori Fund’s Dan Niles called the sector a “mixed bag.” He views semiconductors tied more closely to the economy — such as industrials and automobiles — positioned worse in the months ahead versus those tied to generative AI and battered consumer areas like the PC market, which suffered as demand fell off a cliff last year. Like many investors, Niles views Nvidia as a dominant AI play despite its rich valuation . Shares trade at about 56 times forward earnings. During the stock’s recent surge, he said he sold off some of his position. On the other end of the spectrum, Intel , one of the “most-hated semis,” looks inexpensive, Niles said. The stock took a beating last year, falling nearly 49% after the company reported an ugly quarter. But Niles expects its microprocessor business will see a boost from AI adoption. INTC YTD mountain Intel shares up about 24% in 2023 CFRA’s Zino said investors need to beef up their AI investments to get ahead of the trend in its early innings. He likes Marvell and Broadcom because no matter who wins the AI war, these two companies will benefit from the need for chips powering connectivity as servers require more GPUs. Greater demand for high-end chips as companies invest in the cloud and data center should also fuel more business for Taiwan Semiconductor , said Michael Brenner, a research analyst at FBB Capital Partners. “No matter who the winner is in the data center, as people continue to invest in the cloud and invest in the data center, they’re going to need very high-end semiconductors,” he said, noting the stock trades at a forward PE of roughly 15.5 times. Despite its cyclical nature, the shift to electric vehicles should benefit the automotive semiconductor market near-term, Brenner said. This should boost shares of Infineon , with its focus on renewable energy and a resilient electric grid also driving its business. “The bet is the secular growth over the medium term that we get from EVs justifies the kind of near-term cyclical risks that we’re taking by investing in auto semiconductors,” he said. While bullish overall on the setup for the market, Bank of America analyst Vivek Arya recommends investors look at low-beta, high-quality stocks that lagged the rally’s big winners should sentiment sour. That includes names like Analog Devices , which is tied heavily to industrials and autos. Its shares are up 16% this year. Arya highlighted the analog chipmaker’s ” best-in-class ” free cash flows in a note to clients this month. Other potential beneficiaries include Broadcom and KLA Corp , he added. So far this year, many semi stocks that rallied did so on the back of multiple expansion versus earnings beats. In fact, last month Micron rallied even after posting a disappointing quarterly report. While the stock’s given those gains, many investors viewed the print as a sign of a bottom. But that narrative is beginning to change as semi stocks trade at high-teen multiples on average and bake in a recovery, Zino said. That makes any potential upside from here a likely factor of upside to earnings expectations rather than multiple expansion. “If you have a very high valuation and you have a hiccup, that’s probably not going to go very well for you, especially after the run some of these names have had,” Niles said. — CNBC’s Michael Bloom contributed reporting
