2023-12-14 12:24:52 ET
Summary
- SPDR S&P Semiconductor ETF has surpassed its mid-year high, while iShares Semiconductor ETF lags, but the recent trend shows that it is reversing.
- SOXX's strong performance is due to its heavy concentration on AI-related stocks like Nvidia, AMD, and Intel together with other big names with recent momentum driven by prospects of exporting advanced chips to China.
- With 2024 looking to be the year of normalization for the AI theme together with the Fed now appearing more likely to ease monetary policy, XSD's equal-weight approach makes more sense.
Trading at $551.92, the iShares Semiconductor ETF ( SOXX ) is already past its mid-year high of $533, in contrast to the SPDR S&P Semiconductor ETF ( XSD ) which remains below its mid-year high of $231.8 by around $17. Also, judging by the rather interlaced price performances of these two ETFs during the last three years, it looks like XSD's orange chart is likely to roll over SOXX's blue chart again.
Comparison of performance (seekingalpha.com)
The objective of this thesis is to validate this possibility by going through the ability of certain common holdings to provide exposure to the AI theme which has been a catalyst throughout most of this year, while also highlighting how some of the recent price action could have been due to speculation around advanced chip export restrictions to China. There is also the increased likelihood of a more dovish monetary policy by the Federal Reserve going into 2024.
The AI Catalyst in 2023
One of the reasons for SOXX's mouth-dropping performance of 44.8% during the last year is its heavy concentration on names that rhythms with AI or artificial intelligence, like NVIDIA Corporation ( NVDA ), Advanced Micro Devices, Inc. ( AMD ), and Intel Corporation ( INTC ) which make up a sizable 24.11% of its holdings as pictured below. There are also Broadcom Inc. ( AVGO ) with AI networking and QUALCOMM Incorporated ( QCOM ) with its Snapdragon X Elite for running LLMs (large language models). With much lower exposure to these holdings due to its equal-weight strategy as I detail later, XSD has delivered gains of only 18.4%.
SOXX Holdings (www.ishares.com)
These stocks led by Nvidia with its GPU-based AI accelerators produce the chips which are essential in this new era of artificial intelligence. As such they can be used for a variety of purposes ranging from driving ChatGPT-style applications to even training machine learning models that can be used to increase the efficacy of military strategies which is understandably why the U.S. Administration would not like them to fall into the hands of adversaries like China.
This is the reason Nvidia was banned from selling its most sophisticated A100 and H100 chips as early as last year , while for AMD and Intel, it was the MI250 and the Gaudi2 respectively. However, to address these bans, these companies have been developing China-specific AI processors, the most prominent of these being Nvidia's H800. However, around October 17 the U.S. Department of Commerce imposed new restrictions this time targeting these specific processors themselves.
Now, since China is such a huge semiconductor market valued at $200 billion in 2023, and these additional restrictions deny U.S. semis suppliers of AI-related revenues, both semiconductor ETFs were volatile and lost over 10% in just two weeks starting around October 17 as encircled in red below.
Comparison of performances (www.seekingalpla.com)
Subsequently, the start of November coincided with an uptrend in both SOXX and XSD (as illustrated in pale green above) mainly due to the market pricing in rate cuts after the Federal Reserve adopted some moderation by hitting the pause button for a second consecutive time, after aggressively hiking interest rates as from March last year.
Coming to the last leg of the upside, as encircled in deep green, it was most probably the result of a Bloomberg report that the U.S. Commerce Department may be working with Nvidia to allow certain AI chips to be exported to the lucrative Chinese market, which would augur well for chip sales. This possibility is further supported by both semis ETFs outperforming the Invesco QQQ Trust ETF ( QQQ ) in blue, showing that there is more to the upside than just broader optimism for tech because of rate cuts.
Excessive Optimism in 2023 Could Result in Volatility for SOXX
Now, it can be envisaged that restrictions are removed for certain types of commercial AI chips used by the likes of Alibaba Group Holding Limited ( BABA ) to train its intelligent cloud, but the market seems to already have moved ahead which is not justified as things are still at consultation (exchange of information) phase, and nothing concrete has transpired up to now. Moreover, it can happen that a downgraded version of the H100 in terms of AI functionality is not acceptable to Chinese customers.
Additionally, there is a need for some realism as next year will see the U.S. presidential elections. In this respect, the Commerce Department has been criticized by the Republican Party for giving priority to trade rather than applying tough curbs to sophisticated technology exports to China. Therefore going into 2024, and since China has already been the subject of hotly contested debates between Democrats and Republicans, the Biden Administration would not like to be viewed as "soft" on the policy front. In these circumstances, the "excessive optimism" is not justified, and may give way to volatility as reality bites in.
At the same time, there is a growing consensus of a soft landing scenario whereby a U.S. recession is avoided. The reason is that the restrictive interest rates have been largely successful at combating the very elevated levels of inflation seen since last year and going into 2024, the Fed could remove some of that restrictiveness, as per the last FOMC meeting on December 13. This signifies an economic environment of gradually slowing growth , but no recession.
In these circumstances, it is better to opt for broad diversification enabled by XSD's equal-weighted approach instead of being overweight on a market cap basis. For this purpose, and as seen in the table below, the ETF has exposure to the big names but, each holding's weight is restricted to 3.5% signifying fewer concentration risks. Moreover, it tracks the S&P Semiconductor Select Industry Index which includes 39 holdings, or four more than SOXX.
Apart from being less concentrated, another of XSD's advantages is that it includes many smaller names like Impinj, Inc. ( PI ), Synaptics Incorporated ( SYNA ), and others that have largely been operating in the shadows of semiconductor giant Nvidia which, by the way, forms part of the list of Magnificent 7 with six other names including Microsoft Corporation ( MSFT ) and Apple Inc. (AAPL).
These seven stocks have been driving S&P 500's upside for most of this year but things have started to change in favor of smaller stocks as seen on the right side of the chart below. Hence, some of XSD's holdings have started gaining momentum since the beginning of November with a Dovish Fed, and the likelihood of smaller stocks getting traction is supported by Seeking Alpha analyst Steven Cress in his thesis entitled "2024: A Rotation out of the Magnificent 7".
www.ycharts.com
XSD's Equal-Weight Approach Deserves Better But There Are Risks
Therefore, driven by the momentum of its equal-weight holdings, XSD has been playing catch up with SOXX since the beginning of this year, as evidenced by the price performance differentials gradually shrinking. Thus, from -26.41 % in favor of SOXX for the one-year performance, the one-month performance of 4.67% in favor of XSD, shows that the SPDR ETF has started to roll over.
Table built using data from (www.seekingalpla.com)
Assuming that this market move is sustained, I have a target of $243.1 (215.12 x 1.13) for XSD based on it is trading at a 30% discount considering its lower price-to-book multiple of 2.98x compared to SOXX's 3.88x . Investors will notice that I have applied only a 13% multiplier on XSD's current share price of $215.12 as the economy is slowing down plus a downturn in euro zone business activity. Still, to support this target, chips are an important component of the broader digital transformation trend, and the semiconductor market is expected to grow by 13.1% in 2024.
As such, XSD's holdings can profit from the United States onshoring the chip supply chain as part of the CHIPS Act and China prioritizing industrial development instead of wider demand stimulus. Now, whether it is power generation systems, EVs, or factory automation, these all require semiconductors, not necessarily the latest AI chips which are subject to export restrictions but rather more lagging edge but still highly specialized semiconductors produced by the like Wolfspeed, Inc. ( WOLF ) which obtain revenues from China and has previously faced demand softness from that country.
However, on a cautionary note, XSD has been volatile as seen both on December 12 and lost around 0.22% as a result of the market reaction to CPI numbers, which were higher than expected for November. On the other hand, SOXX gained by 0.75%, probably due to continued enthusiasm around advanced chip exports to China. Therefore, any unfavorable numbers about inflation surging again or rates being maintained higher for longer may be unfavorable for XSD, which has limited exposure to AI and may be less insulated against volatility.
XSD is Better Suited for 2024
To this end, after enjoying a momentum-led 2023 driven by the AI theme, SOXX has already seen some moderation when comparing its recent price performance with XSD, and this should continue in more normalized market conditions.
Interestingly, XSD charges the same fees as SOXX or SMH, or 0.35% despite its more elaborate selection and retention process. For this matter, the issuers have to perform regular rebalances of the portfolio whereby after a stock appreciates and its weight climbs above the fund's objectives, some shares have to be sold and the proceeds allocated to stocks that have underperformed. For this purpose, it tracks the S&P Semiconductor Select Industry Index, which uses a modified equal-weighted approach to provide unconcentrated industry exposure across large, mid, and small-cap stocks. Therefore, it allows investors to take positions at a more targeted level than classical market cap-weighted indices.
Viewed from this perspective, XSD also makes sense for diversification purposes, namely for those already invested in SOXX, and wanting to park some of that long-held cash in semis. This is better than opting for another modified market cap-weighted fund like the VanEck Semiconductor ETF ( SMH ) which is also highly concentrated with heavy names like the ones I mentioned previously.
Finally, this thesis has shown that the time for XSD to outperform SOXX has come and its equal-weighted strategy is better suited for market conditions in 2024.
For further details see:
XSD Seems Better Than SOXX Going Into 2024