With the fourth quarter in the books, we’re now closing in on the first quarter, and the markets have been in a holding pattern near their all-time highs. The question is where do the markets stand to go from here? On an industry-by-industry basis, the tech sector is usually a good leading indicator on what direction the markets might be heading. One key analyst has shared some thoughts on semiconductors.

After the most recent earnings season, Jefferies has continued to observe a number of signals that indicate the cycle is close to peaking: Semiconductor stocks raised estimates with first-quarter outlooks but have traded down. These earnings estimates are at peak levels, and days of inventory (DOI) increased slightly from a trough.

However, the firm remained Neutral on the sector as estimates suggest modest inventory destocking in the second half of 2017. Overall Jefferies likes NVIDIA Corp. (NASDAQ: NVDA), Advanced Micro Devices Inc. (NASDAQ: AMD), Analog Devices Inc. (NASDAQ: ADI), Microchip Technology Inc. (NASDAQ: MCHP) and Broadcom Ltd. (NASDAQ: AVGO) among the large caps.

Over half of the semiconductor stocks in the coverage universe raised first-quarter estimates, but less than half traded up the day after providing those outlooks. This pattern of raising and trading down suggests high expectations are built into the group.

As mentioned previously, the forward earnings estimates for semiconductors are at peak levels. Historically, Jefferies pointed out that the group usually sells off three to six months before downward estimate revisions begin, even as estimates are revised up. This work suggests earnings estimates have sharply risen as a result of inventory restocking, coupled with secular trends.

Jefferies’ DOI analysis suggests semiconductors benefited from inventory restocking over the course of 2016 as DOI declined during the year. After troughing in last year’s third quarter, semiconductor DOI increased slightly in the fourth quarter. The firm noted that DOI troughs, followed by increasing DOI, have been leading indicators for cycle peaks, as a period of shipping in excess of demand was typically followed by an inventory correction.

While peak earnings and trough DOI are bearish indicators, the brokerage firm explained that consensus estimates forecast semiconductor year-over-year growth to decelerate in the second half of 2017 while original equipment manufacturer (OEM) year-over year-growth accelerates, resulting in semiconductors undershipping demand in the second half of the year. This could prove optimistic, but for now its bearish concerns are tempered by rational expectations for inventory destocking.

Jefferies finished by saying:

We moved to a neutral sector stance due to cyclical concerns–and those concerns remain–however, we note the semi cycle has become more muted and therefore believe that select semi stocks can appreciate during a down cycle.

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