Tech stocks have been on a remarkable run, at least as measured by the tech-heavy Nasdaq Composite Index. The Nasdaq rose a heady 46% in 2009, and another 26% in 2010, a more modest 4% in 2011 and a respectable 10% in 2012. Yet one area of the high-tech sector has not been nearly as fruitful. Semiconductor stocks, as measured by the Philadelphia Semiconductor Index (SOX) fell 7% in 2011 and another 2% in 2012.
But thanks to the powerful rally that kicked off the New Year, the "SOX" has just moved above its 200-day moving average. Chip stocks have been moving up from lows seen in November, which may be part of a longer-term trading pattern: According to 20 years worth of data compiled by FactSet Research Systems (NYSE: FDS), chip stocks have tended to rise 11% in the first four months of the year, fall 4% during the next five months, and then finish the year with a strong 7% gain during the final three months. In other words, from Oct. 1 through the end of April, this group has historically tacked on an 18% gain.
And on a fundamental basis, the stars are aligning for the sector's strongest year since 2009, when the SOX rose a solid 39% (1999 and 2003 were other notably strong years for chip stocks).
Broadly speaking, semiconductor stocks lag the broader market and then every once in a while, sharply outperform the market (Goldman Sachs' research found that the SOX outperforms once every five years). The key to outperformance: a drawdown in chip inventories throughout the supply chain, which triggers firmer pricing and higher profits. That's notable considering that industry-wide supplies of chips are down roughly 15% from their peak, according to industry analysts.
You can make a direct connection between industry inventories and stock prices: "There have only been two other cycles in the past 15 years where (inventories) have been more than 10% below trend for multiple quarters, and both of these corrections (in 2001 and 2008) were followed by solid upturns," according to Goldman's James Covello.
To make money with these stocks, you need to buy them before industry figures improve. Analysts believe industry revenues likely fell around 5% in the fourth quarter of 2012, which means industry purchasing agents continue to work off existing inventories. To be sure, the fall in demand can be partially attributable to slumping PC sales. Yet sales of chips used in communications, networking, automotive systems and other applications have also been below trend in recent quarters, and it's these niches that are expected to see firming demand in 2013 as inventory restocking begins.
With tight supplies and firming demand, a wide range of industry players may benefit. Goldman Sachs is especially bullish on NXP Semiconductors (Nasdaq: NXPI) and Freescale Semiconductor (NYSE: FSL), as both stocks are poised for margins gains and robust profit growth in 2013.
I'm partial to the (exchange-traded fund) ETF route for this sector, as a rising tide should life many boats. For example, the PowerShares Dynamic Semiconductors ETF (NYSE: PSI) has exposure to a broad range of chip stocks such as Linear Technology (Nasdaq: LLTC), Broadcom (Nasdaq: BRCM), Analog Devices (NYSE: ADI) and Maxim Integrated Products (Nasdaq: MXIM).
These firms have exposure to a range of other industries outside of the typical computer segment. Linear Technology, for example, makes chips that help manage power supplies in various devices, while Broadcom supplies chips to a number of wireless service base station and handset providers.
The SPDR S&P Semiconductor ETF (NYSE: XSD) offers even more diversification as no single position accounts for more than 3% of the fund. The ETF has exposure to clean energy, computing graphics, LED lighting, flash memory, audio chips and many others.
If you are especially bullish on chip stocks, then the leveraged ETFs are an even better fit. The Direxion Daily Semiconductor Bull 3X Shares (Nasdaq: SOXL), for example, moves at three times the rate of the underlying Philadelphia Semiconductor Index. This index hit $70 a share in early 2011, but has traded down to around $30 in recent months.
Risks to Consider: Chip stocks may be hard-pressed to rally if the broader Nasdaq slumps. That index has posted a remarkable four-year rally and may be due for a breather.
Action to Take --> The technicals and the fundamentals suggest a new chip stock rally is underway. We'll get a clearer read on industry inventory levels as earnings season kicks in over the next month. Don't expect this group to post stellar fourth-quarter results, but bullish forward commentary may be the catalyst to get this group moving higher.