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On AI Global Mess, AI Tokenomics & Better Breadth
Many emerging market economies aspire to become regional AI hubs, importing the technologies needed for their infrastructure from the US or China. The US had seemed the better option given concerns about Chinese data privacy and misinformation. Now uncertainty over whether the US will slow AI deployment changes that calculus. William says that could give China “a far deeper hold on the digital plumbing of the 21st century.” … Also: Melissa explains why falling AI token prices aren’t the negative for AI providers one might assume and why we’re bullish on “tokenomics.” … And: Joe explains how the midterm elections broadened the S&P 500’s breadth.
Asia’s AI Rollercoaster Ride
South Korea and Taiwan had been counting on AI-related export demand to sweep them to prosperity. But another sweep, of Democrats in the US Congress, has sparked doubt and deep stock market declines. What’s next for the Asian AI trade? William shares his thoughts. … Toby opines on what newly depressed valuations in the Korean and Taiwan stock markets mean for investors, noting that analysts’ earnings sights remain aloft. … Also: Japan’s stock market stumbled by association with its Asian neighbors, but perhaps unduly: Its investment case doesn’t rest on AI. … And: China claims to have passed an important milestone in AI development.
Semiconductors Are Still Cyclical, But With A Bullish Long-Term Trend
I. Semis Cycle Historically, the semiconductor industry has been notoriously cyclical. When chip demand outpaces supply, shortages boost prices; higher prices in turn slow demand. High prices boost profit margins and stimulate manufacturers to expand capacity. As demand moderates and new supply comes online, pricing power weakens, and earnings growth slows or even turns negative. In other words, the best cure for high chip prices is high chip prices. The AI boom has created an extraordinary imbalance between chip demand and supply, fueling surging semiconductor prices, revenues, earnings, and stock prices alike. But a key divergence has emerged recently. Forward earnings growth for the companies in the S&P 500 Semiconductors industry has soared to 175% y/y, while the gains in the industry's stock index plummeted from 130% y/y earlier this year to 9% currently (chart). Historically, the y/y percent change in the Semiconductor stock price index has tended to peak before earnings growth peaked and bottom before it recovered. The latest divergence suggests that investors may already be anticipating a peak in earnings growth. We think investors may be partially right: Demand for chips should continue rising as the AI revolution drives ever-greater demand for computing power; that should propel earnings growth. However, financial, political, and physical constraints are creating speed bumps for the AI investment boom, which should moderate the pace of growth in both chip demand and earnings. One physical constraint is expanding semiconductor manufacturing capacity, which should gradually increase supply. As the gap between demand and supply narrows, pricing power and profit margins could come under pressure. That would slow earnings growth. That said, memory makers have sharply increased their use of long-term agreements (LTAs) with hyperscalers, moving from quarterly or annual contracts to three- to five-year deals backed by substantial prepayments, which should help cushion a potential slowdown. Micron alone reported roughly $150 billion in contracted future revenue last quarter. The Semis' earnings boom has been fueled by both remarkable revenue growth and expanding profit margins. Forward revenues is up 121.2% y/y, while forward earnings has grown even faster at 175.1% (chart). As a result, the industry's forward profit margin has reached a record 51.8%, nearly doubling from its early-2023 level (chart). These extraordinary margins reflect the pricing power that semiconductor companies have enjoyed as demand has outstripped available supply. The anticipation of peak earnings growth may have contributed to the recent drop in semiconductor stock prices. The S&P 500 Semiconductors stock price index has plunged roughly 27% from its recent peak through November 6, falling below its 200-day moving average (chart). Nevertheless, its uptrend remains intact, in our opinion. The selloff has also been evident in Semiconductor ETFs, which have retreated sharply from their recent highs (chart). II. Earnings & Valuation Despite the recent selloff, semiconductor fundamentals remain strong. Forward revenues per share for the S&P 500 Semiconductors industry has soared to a new record high, reflecting the extraordinary demand for chips generated by the AI investment boom (chart). Forward earnings per share has climbed even faster, as the wide gap between chip demand and supply has given manufacturers significant pricing power and driven profit margins higher (chart). Soaring earnings estimates and the recent decline in stock prices have compressed valuations. The industry's forward P/E has plunged to just 13.1, well below the S&P 500's 18.7 and the Information Technology sector's 18.4 (chart). Historically, Semiconductor P/Es have tended to bottom near earnings-growth peaks and recover as earnings-growth expectations bottom and turn higher. We suspect that such a recovery could cushion stock prices as forward earnings growth moderates to more sustainable levels, with speed bumps slowing—but not derailing—the AI investment boom. III. Fundamentals The AI boom continues to fuel growth in global semiconductor sales, which reached another record in September (chart). The three-month average through September was $172.6 billion, or over $2.0 trillion annually. Much of the recent surge is due to higher prices, as the industry is capacity constrained. Yet the US producer price index for semiconductors and related devices fell 2.2% y/y in September (chart). The broad index is declining despite a chip shortage as shortages are concentrated in advanced AI chips and memory, while pricing conditions for conventional semiconductors remain weaker. Surging AI demand has created acute shortages for memory chips, pushing their prices sharply higher. JP Morgan estimates that DRAM prices will rise by more than 400% from the start of 2024 through the end of 2026. These price pressures are also feeding into prices for computers and related equipment (chart). IV. Market Cap & Earnings Shares Semiconductors have become the dominant earnings growth engine of the Information Technology sector. Historically, their shares of the sector's forward earnings and market capitalization moved largely in lockstep. That relationship has recently broken down, as investors anticipate a peak in earnings growth, leading to multiple compression. Semiconductors now account for a record 54.8% of the sector's forward earnings, compared with 41.0% of its market capitalization (chart). Prior to 2023, when the AI boom started taking off, there was less of a gap between these two shares, with both fluctuating between 10% and 20%. The same pattern is evident across the S&P 500, where Semiconductors accounts for 20.4% of forward earnings and just 15.9% of market capitalization (chart). Nevertheless, these figures underscore the industry's growing importance to the broader market, since both shares fluctuated mostly below 4% prior to 2023. The Semiconductors industry’s forward revenues is growing far faster than those of the broader Information Technology sector and S&P 500 (chart). Cyclical forces are likely to moderate the former. The outperformance is even more striking in forward earnings growth (chart). Again, cyclical forces are bound to slow this down. The bottom line is that the Semiconductors industry remains cyclical, but with a very bullish long-term trend. Accordingly, we view the latest selloff as a buying opportunity.
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