Chip ETFs Down, May Be Out for a While

Semiconductors have been one of the worst-performing sectors in 2008.

So far this year, the Dow Jones U.S. Semiconductor Index has fallen 44.8%, while the S&P 500 is down 33.9%. Semiconductor ETFs have similarly felt the agony of the selloff. The PowerShares Dynamic Semiconductors Fund ( PSI), the Semiconductor HOLDRs Fund ( SMH) and the SPDR S&P Semiconductor ETF ( XSD) have seen respective year-to-date declines of 39.4%, 39.09% and 35.3%.

Investors who have taken the other side of the trade have fared much better. Of the 812 ETFs tracked by Morningstar, the top-performing ETF has been the UltraShort Semiconductor ProShares Fund ( SSG). The fund is designed to return shareholders twice the inverse of the daily performance of the Dow Jones U.S. Semiconductor Index.

The semiconductor industry's transition in focus from businesses to individuals has been part of the downfall this year as consumers have been reining in spending. "Over the past 10 years, there has been a fundamental shift from corporate IT to consumer demand," said Ken Nagy, a senior analyst for Zacks Investment Research. "The shift will continue in the years ahead, as consumers all over the world are captivated by the richness and portability of digital media."

This trend could lead to additional challenges for semiconductors. "This shift leads to seasonal demand in the sector," Nagy said. "It also leads to the potential for more commoditized products and average selling price erosion."

Demand Destruction

Betsy Van Hees, a vice president and semiconductor analyst for Caris & Co., agrees with Nagy that this shift is a major concern for the sector. "The biggest risk for the sector right now is a slowing of demand," she said. "And if consumers continue to be cautious, we could see a further slowing of demand."

Van Hees believes it could be some time before semiconductor companies are able to recover from recent hits they have taken. "We're going to be heading for continued challenging times," she said. "Valuations are so low right now, but they are moving targets as estimates are revised. We are looking for demand to pick up in the second half of 2009."

One bright spot she sees in the sector is sound inventory management. "I am finding inventory levels to be very lean right now," Van Hees said. "That's a very encouraging sign."

One difficulty in using ETFs to play semiconductors is that there are segments of the semiconductor space as well as individual companies that hold prospects that are much more promising than some of their peers. "We are optimistic on semiconductors in the wireless space," said Eric Aanes, president of Titus Wealth Management. "We're not as optimistic on flash memory and DRAM."

Aanes acknowledges there could be some short-term downside risk for semiconductors, although he thinks the sector has sound long-term prospects. "We think that this sector will have a lot of snap-back when we come out of this market slump" he said. "Sometimes you need to lean into the pain."

Individual Plays

As far as individual names go, analysts have some stocks in mind for investors who aren't sold on a semiconductor ETF play. Broadcom ( BRCM) is a favorite pick for both Aanes and Van Hees. "The company has a great balance sheet, a lot of cash and a diverse product offering," said Van Hees.

In addition to Broadcom, Aanes also likes Intel ( INTC) and Qualcomm ( QCOM). "We think that they both have a great future in the wireless space," he said.

Nagy favors some of the semiconductor names that benefit the energy sector. "Older technologies deliver power inefficiently, often consuming two or three times the amount of power needed by the end product and wasting substantial amounts of energy," he said. "Firms that provide solutions to so-called 'energy vampires' will outperform."

His top pick in that arena is Power Integrations ( POWI)."

Suppliers to green energy may also benefit, particularly Solar Power ( SOPW.OB) and MEMC Electronic Materials ( WFR).

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