Chip Stocks Suffer Amid Recession Fears, High Valuations Aren't the Only Headache

Thursday's release of multiple economic data points all showed poor performance, reigniting fears of a recession due to deteriorating macro demand expectations and weak employment figures. This led the market to experience a significant decline. Simultaneously, leading chip design giant Arm's projected growth rate for patent licensing fees, which benefit from the AI-enabled smartphone trend, fell below previous expectations. This indicates a lack of confidence in future growth prospects and further dampened sentiment in the semiconductor sector.

Before the much-anticipated interest rate cut, more and more signs indicate that the risk of economic recession in the US is rising. In July, the US manufacturing PMI contraction reached the largest in eight months. On the same day, the US June construction spending monthly rate also recorded a -0.3%, the largest decline since October 2022, far below the expected 0.2%, and the previous value was revised down. The labor market is also slowing down, and last week's initial jobless claims hit a one-year high. The FOMC statement no longer says "still highly concerned about inflation risk," but instead focuses on the risks facing the dual mission of employment and inflation. Investors are anxiously waiting for the July non-farm payrolls data to be released on Friday morning. Once the unemployment rate rises to 4.2%, it will trigger the economic recession alarm of the Sahm Rule, and the accuracy rate of this indicator in predicting the past 50 years is 100%.

The market is concerned that the looming economic slowdown will cause chip stocks to be in trouble because the cyclical nature of the chip industry means that it is very sensitive to the ups and downs of downstream demand. The market is concerned that after spending high R&D expenses, the sales prospects of semiconductor companies are not as optimistic as expected, and companies that purchase chips are struggling in the deteriorating economic environment, which directly affects the profitability of chip companies.

The trend of gross profit margin data of major semiconductor companies also shows that the profitability of most chip companies is not as good as expected. Although companies such as Nvidia and AMD have benefited from the strong demand for AI chips, their gross profit margins have improved since early 2022, but the gross profit margins of most peers have actually declined in the past two years.

The latest industry outlook data from the World Semiconductor Trade Statistics Organization (WSTS) also shows that the analog chip market, which plays an important role in the chips required for EVs, is still sluggish. The market size is expected to continue to shrink by 2.7% in 2024 after shrinking by 8.7% in 2023.

Although large tech companies such as Google and Amazon have emphasized their determination to increase capital expenditures in the AI field and have clearly stated the necessity of investing heavily in AI chips designed by companies such as Nvidia, the fluctuations in business progress and potential regulatory risks have cast another shadow over Nvidia's stock price.

There have been rumors recently that Blackwell, which Nvidia had planned to mass-produce in Q4 2024, may be canceled, and the commercialization of the Blackwell platform may be delayed. At the same time, according to five people familiar with the matter, the US Department of Justice is investigating Nvidia's acquisition of the AI startup Run:ai on antitrust grounds.

Despite the recent pullback in chip stocks over the past three weeks, the valuation of the semiconductor sector remains at a high level. There are concerns in the market that the current high valuation may not be offset by earnings growth, and any underwhelming earnings performance in the next phase after sell trades based on the correction of high valuation may trigger further selling.

The high valuation has raised higher expectations for the financial performance of chip stocks during the earnings season. Any imperfections will be magnified and seen as a signal of insufficient industry prosperity. Apart from quarterly revenue and net profit, any signs of weakness in business development, unadjusted performance guidance, lack of confidence in executive statements, and undisciplined capital expenditure will be magnified. In the short term, the disruptive factors for semiconductors far outweigh the supporting factors.

From the perspective of fund preferences and fund flows, the current dominant trading themes are as follows:

Rate-cut trade: The anticipation of an interest rate cut has triggered sector rotation, leading capital to flow from overvalued semiconductor stocks towards underperforming sectors.

Trump trade: Betting on Trump's re-election favors traditional energy, finance and domestic US companies, while high-tech semiconductor stocks with significant overseas exposure may not have an advantage.

Risk-off trade: As tensions escalate in the Middle East, investors tend to favor safe-haven assets such as gold and US Treasury bonds for risk aversion.

1. Option Hedging: Based on different judgments on the depth of market decline and volatility, investors can choose various option strategies to hedge their position risks, including:

● Protective Put: Investors can protect their existing investments by purchasing put options while holding stocks. This limits the losses during a downturn while retaining the potential gains from stock appreciation. However, investors need to pay attention to the critical cost of options premiums.

● Covered Call: Investors can sell call options to receive premiums while holding stocks. Although this can hedge the downside risk of the underlying stock by collecting options premiums during small stock fluctuations or when no significant upside is expected, investors may lose potential profits if the market experiences a significant rebound and the option is exercised. In addition, this strategy provides limited protection during significant market downturns.

● Collar: Investors can buy protective put options and sell call options to lower costs while holding stocks. This combines the advantages of protective put options and selling call options, providing downside protection and generating additional income. However, if the stock rises significantly, the sold call options may limit profits, and if the stock falls, the cost of the purchased put options needs to be paid.

2. Reverse ETF Hedging or Betting on the VIX Index: In addition, investors can choose to hedge their holdings using reverse ETFs or bet on ETFs linked to the "VIX" fear index.