Recent High Notes Aside, Chips' Tune Still Downbeat

How lame does a recovery have to be before it stops sounding like a recovery? Check out the chip sector for an uninspiring example. So far, signs suggesting a hoped-for holiday uptick didn't translate into much -- if anything -- for semiconductor outfits, based on this week's miserable results from Micron ( MU) and weak reports on PC buying from the likes of Best Buy ( BBY).

That's why investors should be ultra-cautious when the market cheers potential signs of recovery. Despite some signs that the chip business is stabilizing, amid three straight quarters of industry revenue growth, there remain as many reasons to tread lightly as there are to be optimistic.

Amid growing recognition of that fact, the benchmark chip index has quietly edged down from its near-term high of 382 on Nov. 27, sliding 22% as of Thursday's close.

Fingers on the Trigger

Yet everyone's clearly itching for the turnaround to start. Just last week, Wilfred Corrigan, head of LSI Logic ( LSI), issued a bullish pronouncement on '03, telling Reuters, "The industry and the customer base are trying to get up from the bottom and that's going to happen next year. I'm sure of it." LSI makes silicon for storage and communications markets.

Earlier this month, investors bid up Intel ( INTC) in the week leading up to its December midquarter update, betting correctly it would raise sales guidance (though it's worth noting that the new outlook for growth of 5% to 8% remains well below the double-digit growth typical for this time of year).

In other upbeat news welcomed in an industry plagued by harsh price declines, Intel said it plans to hike prices of some types of flash, a kind of silicon used in wireless and digital camera applications, as much as 40% next year.

One more bit of incremental cheer: Wednesday a report showed that the November book-to-bill ratio for chip equipment, a favored measure of industry health, came in flat after five months of declines -- a likely indication that business has finally stopped deteriorating.

There's no question those are welcome signs to investors starved for good news. But as this week has made clear, it's also true that companies and analysts who've geared up for growth this quarter have lately had their hopes dashed. DRAM maker Micron delivered sales 15% below expectations, prompting shares to plunge 23% since.

On Wednesday, Intersil ( ISIL) said it's seeing "significant" push-outs in shipments of WLAN chips, causing it to warn of a sales drop-off from the prior quarter.

Meanwhile, the latest financial results from retail box stores were underwhelming on the PC side, with Best Buy reporting that computer sales fell year over year. Remember, that's true despite heavy discounting from leading PC vendors. Hewlett-Packard ( HPQ), which recently lost its market leadership in PCs to Dell ( DELL), has gone on the price-cutting warpath, with bedraggled Gateway ( GTW) joining in the action.

The latest reports shouldn't come as a surprise, says Nimal Vallipuram, an analyst at Dresdner Kleinwort Wasserstein. "In the case of Intersil and Micron, I think the sustainability of end-market demand is still absent," he says. Vallipuram recommends his firm's clients steer clear of semiconductors, at least for long-term investments. "There's too much uncertainty to put money in semi-stocks. An economic recovery has to happen coincidentally with a semi-recovery. And if we're going to war, oil prices will shoot up and there won't be an economic recovery in the near-term."

Indeed, to put the so-called recovery now under way in perspective, consider that global chip sales this year are expected to rise only 2% from last year's levels, when a staggering drop-off in demand led to the worst year in the industry's history. That's true even though revenues have crawled upwards all year, creating a sickly kind of momentum.

Despite some growth in chip sales, Vallipuram disputes the notion that the industry is in rebound mode. For a recovery to take place, he says, he expects to see six to eight quarters of growth and a sustainable increase in capacity utilization to the 80% to 85% range. Another prerequisite: a rise in average selling prices.

Until the picture clears, "The best thing to do is stay out of the semi-stocks," says Vallipuram. "The only way to make money in them is to be extremely attuned to valuation, and that's not easy."

If you'd loaded up on chip shares at the beginning of 2002, back when analysts were predicting a bounce-back this year, "you'd be sitting on horrendous losses," he points out. On Jan. 2, 2002, the Philadelphia Stock Exchange Semiconductor Index stood sweetly poised at 545; nearly a year later, it's nearly dropped in half.

From an investor standpoint, it may be worth ignoring the short-term noise and noting the words of none other than Intel Chairman Andy Grove. Last week, he said bluntly that it's too soon to forecast a rebound in semiconductors, according to a Reuters report. "The beginning of the end? I wouldn't be so optimistic," said Grove.

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