By William Tretn, CFA of Stock Market Beat

A comment on a recent post ignited an important debate. Important enough, we felt, to expand upon our thoughts in a full post.

reinharden Says:
Your premise that “demand has risen pretty steadily over time” only holds true for fairly variable values of “pretty steadily” and neglects entirely the lessons of the last decade.

For example, 2001, 2002, 2003, and 2004 were all smaller years than 2000. Demand fluctuated. Hell, from 2000 to 2001 it cratered.

We aren’t disagreeing as much as reinharden might believe. The fact that demand cratered from 2000 to 2001 is actually part of our premise – why we are concerned about the recent expansion in semiconductor industry capacity. Here is a chart of worldwide semiconductor sales since 1996, to evaluate our claim that demand has risen pretty steadily over time.

So, yes, there was a falloff in 2001. But (also yes) there was otherwise a fairly steady growth pattern over the 10 years. So the question is why was there a falloff in 2001? For that, we turn to our favorite chart of all, the excess capacity chart.

You see, beginning in 1999 and continuing through 2000, the growth rate in semi equipment orders was faster than the growth rate in semiconductor demand. Here’s how reinharden explains the capacity expansion process:

Anyway, you’ve also got to keep in mind that you’ve got to order semiconductor equipment at least 6 months to 18 months ahead of when you’re going to get it delivered and add another 6 months to 12 months to get it installed and the problems with your processes resolved. Which means that you’re ordering equipment now in the hopes that you’ll need it two or three years from now.

So by 2000 most of the capacity was in place, churning out chips. Since end demand was growing at a slower pace, inventory built up. The falloff in 2001 wasn’t so much a drop in demand, but the fact that the demand could be filled from that existing inventory.

Now comes the fun part – look at what happens to the semiconductor stocks during periods when they are ordering equipment at a faster rate than end demand, compared to when they are ordering equipment at a slower rate:

A very simple trading rule of buying the SOXX in the first month demand (semiconductor sales) grows faster than supply (semi equipment orders) and selling the first month that supply grows faster than demand is consistently profitable. Every time. The amount varies, but the longer and stronger the supply/demand imbalance, the more money the simple rule can make.

Reinharden says “Standing pat doesn’t win success in the semiconductor market. Companies that hop off the treadmill pretty much are destined to long-term obsolescence.” That may be true for semiconductor companies. But for the people who invest in them, it makes more sense to hop on and off the treadmill at the approprate times.

The author may hold a position in the securities discussed. The author’s current holdings are as follows: Long: Union Pacific (UNP) put options; Air Products (APD) put options; Bookham (BKHM; Ballard Power (BLDP); Syntax Brillian (BRLC); CMGI (CMGI); Genentech (DNA); Ion Media Networks (ION); Three Five Systems (TFS); IShares Japan (EWJ); StreetTracks Gold (GLD); Starbucks (SBUX); U.S. Oil Fund (USO); Plantronics (PLT) call options; Short: Landstar (LSTR) put options; Plantronics (PLT) put options;

http://stockmarketbeat.com/blog1/

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