How the chips may tell advisers whether to ‘buy-on-the-dips’ or not

When it comes to technology stocks, the leading maker of graphics processing units (GPUs) NVIDIA may not be as well-known as Microsoft or microprocessor (MPU) king Intel, let alone Facebook, Apple, Amazon, Netflix and Google’s parent Alphabet, the so-called FAANG stocks.

But, alongside Tesla, NVIDIA has acquired quasi-FAANG status, helped by the phenomenal capital gains which it has provided to advisers and clients, either directly or, more likely, via indirect investment in active or passive funds that specialise in tech stocks or US equities.

This makes the company – and its sudden travails, in the form of a profit warning and steep share price slide – interesting to this column for two reasons. First, it puts further pressure on the tech sector, which has been a rare source of juicy capital gains for advisers and clients in 2018. Second, it brings silicon chip stocks in particular back into the spotlight. Regular readers will know that this column likes to follow the main index for chip makers, the Philadelphia Semiconductor index, or SOX, since its record as an indicator for global economic and financial market health looks pretty good, dating all the way back to its inception in summer 1994.

Digging a hole

Advisers and clients are unlikely to have either the time or the inclination to get too heavily into stock-specific details but in NVIDIA’s case it may be worth making an exception, because the cult, US-listed stock is often bracketed with the FAANG quintet and it now looks to be blowing a fuse.

The leading manufacturer of silicon chips has issued a big profit warning (15 Nov ’18) for the final quarter of its financial year (the three months to the end of January), citing indigestion in the video consoles market and also a slowdown in demand from makers of Bitcoin mining equipment.

As a result, a stunning run of increases in quarterly sales and profits is about to come to a crashing end, with founder and Chief Executive Jensen Huang forecasting a 7% year-on-year drop in sales and a 28% year-on-year plunge in operating profit for the fourth quarter.

NVIDIA’s run of sales of profit growth looks to be hitting a speed bump

Source: NVIDIA accounts, Q4 estimate based on management guidance issued on 15 November 2018

That punctured the high-flying shares and left them at levels last seen in September 2017.

As the chart shows, after NVIDIA’s meteoric rise, this one was never going to plateau – it was either going to keep on going up like a rocket or come down like the stick.

Three issues

At the moment it looks like gravity may be starting to win, although this is not to say NVIDIA cannot bounce back.

NVIDIA’s meteoric share price momentum is coming under threat

Source: Refinitiv data

However, the trading alert does mean that advisers and clients must now mull over three issues.

  • Is it time to keep buying on the dips? A stock market bull run that is nearly ten years old has conditioned many market participants to use any share price weakness as a chance to pile back in but like all investment strategies this one works well - until it doesn’t. It may not be obvious from the long-term share price chart but NVIDIA’s shares fell by more than 80% in both of the 2001-03 and 2007-09 bear markets. A repeat this time would take NVIDIA back to barely $60 – still miles below the $167.5 indicative price in after-hours trading.
  • Is this a stock-specific situation or indicative of wider problems for end-demand for silicon chips? It is tempting to say this is a situation that lies solely with NVIDIA, given the damage done by relative niche markets such as bitcoin mining equipment. But NVIDIA has not been alone in warning of softer end markets. A string of Apple suppliers have coughed up disappointing results, including Japan Display, Lumentum and AMS, while Texas Instruments, Infineon and STMicroelectronics have all issued cautionary outlooks. This feels like it could be broader-based and investors must now keep an eye on NVIDIA’s quarterly balance sheets. A second-quarter jump in inventories and trade receivables warned of a possible slowdown and now it has come to pass, with inventories and receivables rising must faster than sales yet again. Tech-stock bulls will want to see this bulge of finished parts start to diminish to suggest this is just a blip and not an end-of-cycle downturn.

Bulge in inventory and receivables speaks of slowdown in chip demand

Source: NVIDIA accounts, Q4 estimate based on management guidance issued on 15 November 2018

  • What, if anything, does this mean for stock markets more generally? NVIDIA is a leading member of the Philadelphia Semiconductor Index, or SOX index. This benchmark has traditionally been a good indicator of wider stock market momentum and risk appetite since its launch in summer 1994. The index peaked before the wider US stock market in both 2000 and 2007 and bottomed before headline indices such as the S&P 500 began to find its footing in 2002 and 2009.

The SOX index peaked before broader benchmark stock indices in 2000 and 2007

Source: Refinitiv data

This is because silicon chips – semiconductors – are everywhere, from cars and computers, from smartphones and tablets, from video games to robotics and from display screens to data centres so they are a good proxy for economic growth and broader end-market demand. In addition, chip stocks are traded as momentum and growth stocks, doing well when earnings estimates are going up and badly when they are going down.

As a result, the SOX can be a good guide to financial market sentiment more generally.

The SOX had rallied going into the NVIDIA report (15 Nov ‘18) week so it will be interesting to see if it shrugs off the disappointment as we head into the key festive gadget selling season.

The SOX index peaked in March

Source: Refinitiv data

Buyers-on-the-dips will certainly be hoping so, although they may note with some trepidation that the SOX index has yet to recapture the highs reached in March of this year.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.

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