The semiconductor story of 2000: There's just not enough flash in the pan.

Over the past month, the Philadelphia Stock Exchange Semiconductor Index has risen 40%, and you can chalk up that performance to a broad set of supply/demand dynamics that look very favorable to chipmakers. Low availability of some Intel ( INTC - Get Report) microprocessors has forced PC maker Gateway to increase its mix of chips from Advanced Micro Devices ( AMD).

Meanwhile, spot prices for DRAM (Dynamic Random Access Memory) have been creeping higher for months because of tight supply, a problem that's expected to get worse before it gets better.

But this year, when people talk about semiconductor shortages, they're really talking about flash memory. Flash, unlike other memory chips, is able to retain its data when a device's power is instantly shut off, and that characteristic has made it a staple component for a wide array of products that need to store information in very small spaces.

"We're still very early in the adoption of flash memory, because we're still very early in the adoption of the products that use flash," says Drew Peck, semiconductor analyst at SG Cowen. "They're primarily digital cameras, MP3 players and PCs, and the use of flash in PCs is relatively recent. We're seeing an explosion of demand from what was a very small base, and it's difficult for manufacturers to keep up."

Palm Computer , for one, has acknowledged that the paucity of flash memory has left it struggling to meet demand for its handheld devices, which are leaving retailer's shelves as fast or faster than Palm can replace them.

Can You Spare $1 Billion?

Flash manufacturers are drooling over that demand. And not surprisingly, they're responding by raising capacity.

"There's no secret how you build flash memory," Peck says. "Anyone with enough cash can build a $1 billion to $2 billion plant. The way you enter the market is by throwing huge amounts of capital at it."

A host of flash manufacturers, including Hitachi and Fujitsu, have announced dramatic increases in their capital spending budgets, while Intel has set plans to spend $2 billion to increase production at its New Mexico plant over the next three years.

News like that has some observers moderating their enthusiasm over the flash boom, and bracing for the day when excess production turns the flash industry into a commodity business as cyclical as DRAM, oil or pork bellies.

"We're going through a tremendous overbuild," says Fred Hickey, editor of the High-Tech Strategist newsletter, in whose pages he's been warning his subscribers of a coming crash in the flash market. "Every vendor in the world is piling on capacity," he argues.

SG Cowen's Peck is sympathetic, but subdued. "From a purely intellectual point of view, Hickey's right," he says. "But in the world of investing, you can be right and go broke. What's the next piece of incremental news in the flash business? It's probably pretty good. In the short term, for the next quarter or two, I don't see any major disaster shaping up."

Right Here, Right Now

The rest of the analyst community holds pretty much the same opinion. "We will have an overbuild eventually," concedes Mark Edelstone, semiconductor analyst at Morgan Stanley Dean Witter. "But right now, supply and demand are skewed toward excess demand and capacity constraints. And it will remain that way for the next 18 months."

The flash market's rosy near-term outlook could help continue to drive higher the already lofty valuations held by diversified semiconductor manufacturers like Intel and AMD. Edelstone recommends Atmel ( ATML) as a way for investors to participate in the flash buildout. "It does a lot of other things," he says. "But flash is a major part of its business." (Morgan Stanley, which has performed underwriting for Atmel, rates the stock a strong buy.)

There are pure flash plays. Companies like SanDisk ( SNDK) and Silicon Storage Technology ( SSTI - Get Report) produce nothing but flash memory.

Its unadulterated exposure has been particularly kind to Silicon Storage, which has risen from 6 1/4 to 108 1/4 in the last year. That's a gain of 1,600% -- quite a run for a company that lost 20 cents a share last year. But the impressive earnings growth that analysts have forecast make it look progressively cheaper.

The $1.70 a share that analysts polled by First Call/Thomson Financial expect Silicon Storage to earn this year puts its forward P/E around 60. And earnings are expected to double to $3.40 in 2001. If the company finally does hit that number, it will do so right around the time many observers think the flash memory market will reach overcapacity.

Such is the nature of the semiconductor cycle. As Merrill Lynch reminded its clients in the Semiconductor Global Primer it sent out last November, when it comes to the semis, "P/E valuation is of secondary importance, because in an upturn, estimates always rise to make shares look fairly valued." You can assume the opposite's true in a downturn. But until the cycle turns, the sector's bears may do best to lie low.