Time to Cash In the Chips on the Semiconductor Stocks

Stretched valuations and overbought technicals poinnt to a pullback in SMH

Shares of the Van Eck Semiconductor ETF (NYSEARCA:SMH) exchange-traded fund have had a monstrous run since making lows at the $80 area last Christmas. This ETF, which  is comprised of the largest computer chipmakers, is up over 50% this year. This is double the impressive 26% total return of the S&P 500.

Time to Cash In the Chips on the Semiconductor Stocks
Source: Shutterstock

Certainly some of the outperformance was warranted, given the previous pessimism surrounding semiconductor stocks. The red-hot rally has now come too far, too fast though. Time for SMH to underperform over the coming weeks.

SMH is comprised of 25 of the top chipmaking stocks listed on the U.S. exchanges. Taiwan Semiconductor (NYSE:TSM) and Intel (NASDAQ:INTC) are the two largest holdings and account for 25% of the overall weighting. As such, these two chip making giants have the biggest impact on the SMH.

Fundamentals of Semiconductor Stocks in the SMH ETF

A quick look at the current fundamentals of Taiwan Semiconductors show valuations to be at an extreme. The price-to-earnings of 24.5 is at the richest multiple in the past 10 years and at a 50% premium to its 5-year average of 16. The price-to-sales ratio is now at a rather rich 8X, also a 10-year high by a wide margin. The price-to-book ratio just passed 5 for the first time in the last decade.

Intel also just reached a new 10-year high on a price-to-sales basis with a reading of 3.7X. Its price to book is also at a similar extreme at 3.4X. Certainly not cheap on either a comparative or absolute basis.

SMH reached extremely overbought levels on a technical basis before finally pulling back. The 9-day RSI breached the 70 level before turning sharply lower. Prior instances when this occurred marked significant short term tops in semiconductor stocks. MACD just went negative and issued a sell signal. Shares traded at a big premium to the 50-day moving average before finally turning lower.



More importantly, SMH had a reversal day Tuesday. The semiconductor ETF tried but failed to make a new high by a penny, then reversed to close lower on the day. This type of pattern is many times emblematic of a short term top in the underlying. The buyers have finally become exhausted and the sellers have taken control. It is an even more powerful indicator given the strength of the previous rally in SMH and that it happened at all-time highs.

The chart shows that prior instances when the SMH ETF reversed from overbought conditions led to a pullback to at the least the 50-day moving average — or a further drop to the trendline. In this case, that equates to an initial downside target of $125 with an ultimate downside target of $120.

Stock traders should use any strength to short SMH. A meaningful breakout to new all-time highs would be a viable stop out area. Downside profit objectives are at the previously mentioned $125 and $120 levels.

Option traders should look to take advantage of comparatively cheap implied volatility (IV) at only the 17th percentile and buy a put diagonal. The Jan $127/Dec $125 is priced around $2.50. Maximum risk on the trade is $250 per spread. Ideally SMH clsoes near $125 at December expiration. the trade structure allows for additional selling of weekly options to further reduce the initial cost.

As of this writing, Tim Biggam did not hold a position in any of the aforementioned securities. Anyone interested in finding out more about option-based strategies or for a free trial of the Delta Desk Research Report can email Tim at timbiggam@gmail.com. 

Article printed from InvestorPlace Media, https://investorplace.com/2019/11/time-to-cash-in-the-chips-on-the-semiconductor-stocks/.

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