Chip stocks are breaking out on more AI news combined with hopes for an economic soft landing.
Shares of most semiconductor stocks including sector leaders Broadcom (AVGO 5.23%), Arm Holdings (ARM 6.17%), and Lam Research (LRCX 4.92%) were rallying today, with these three up 5.2%, 5.3%, and 4.6%, respectively, as of 12:50 p.m. ET on Wednesday.
These three chip leaders are players within the artificial intelligence (AI) race, and their stocks have seen solid price appreciation in 2024. But that growth stalled last month, as recent inflation reports came in hotter than expected in April.
But today, more positive AI news continued to roll in. Meanwhile, Wednesday saw a softer-than-expected May jobs report. That fueled hope that lower inflation could be in the cards, and strengthened the prospects for Federal Reserve interest rate cuts this year.
Bad news is good news?
This morning, the Automatic Data Processing (ADP) employment report came out for May, showing that 152,000 jobs were added last month, below expectations of 175,000.
Furthermore, the April reading was revised down to 188,000 jobs added. The report also showed that wage gains for job-switchers moderated to 7.8%. The report dovetailed nicely with yesterday’s Job Openings and Labor Turnover Survey report, which also showed falling job openings.
What does this have to do with semiconductor stocks, and why would it be good? Because a softer-than-expected jobs number and wage growth that’s moderating but still solid suggest services inflation might begin to come down, as wage pressures and labor shortages have been a key factor in the services inflation we’ve seen over the past couple years.
A moderating economy that doesn’t tip into recession would be an ideal scenario, enabling the Federal Reserve to cut the federal funds rate this year without needing a recession — what is called a “soft landing.”
High interest rates in particular weigh on growth stocks, which often trade at high multiples, as well as cyclical stocks that can be sensitive to an economic slowdown. And semiconductor stocks have both those qualities, especially since many have seen their valuations run up on expectations of strong AI-fueled growth.
For example, Broadcom and Lam Research have each seen their price-to-earnings (P/E) ratios more than double over the past year to 52 and 35, respectively. Meanwhile, Arm Holdings has always traded at an extremely high valuation since going public in September, with a P/E of 460.
So, the prospects for lower interest rates seem to be lifting the entire chip sector today, especially as the AI growth story remains intact.
AVGO PE ratio data by YCharts.
A report that Taiwan Semiconductor Manufacturing (TSMC) would be investing in the most advanced kind of extreme ultraviolet lithography (EUV) machine this year, called high N.A., suggests that the world’s leading foundry will move rapidly to the latest chipmaking technology.
That suggests AI demand and associated competition continues unabated, and may even be picking up steam, which would be a great thing for these three companies. TSMC makes chips for Broadcom, as well as many chips based on the Arm-based architecture. In fact, TSMC’s biggest customer is Apple, which designs Arm-based chips for its smartphones and PCs.
Qualcomm has also begun producing Arm-based chips for AI-enabled PCs and potentially even servers in a bid to expand its market beyond handsets. Those chips will also be made by TSMC fabs. So the TSMC investment news could mean strong growth for Arm.
A bigger investment in EUV would also be good for Lam Research, whose etch-and-deposition machines are used alongside EUV lithography machines as part of the chipmaking process.
Lam has pioneered a new technology that will likely have to be used alongside high-N.A. EUV machines, like the one TSMC reportedly is buying, in order to prevent defects that more easily happen at extremely fine molecular sizes. Existing processes struggle to maintain design integrity at extremely small sizes, so an acceleration of high-N.A. adoption could mean good things for Lam Research as well.
Image source: Getty Images.
Is the chip cycle getting long in the tooth or just getting started?
The semiconductor sector has broadly recovered from the 2022 lows, with many stocks now up by multiples of their 2022 bottom prices. However, their businesses are really just starting to see a recovery in revenue and profit, driven by AI and a recovery in legacy sectors like smartphones and PCs.
Yet while the upturn is about 18 months old, AI-backed growth could make the boom last longer than prior cycles. And if the Fed can pull off a soft landing with falling interest rates and no recession, so much the better.
Billy Duberstein and/or his clients have positions in Apple, Broadcom, Lam Research, and Taiwan Semiconductor Manufacturing. The Motley Fool has positions in and recommends Apple, Lam Research, Qualcomm, and Taiwan Semiconductor Manufacturing. The Motley Fool recommends Broadcom. The Motley Fool has a disclosure policy.