Have Chip Stocks Come Too Far Too Fast?
Chip stocks are up 40% this year on average, which means that this sector has grown twice as much as the S&P 500 index. Does this mean that we should be afraid?
Fundamental analysts have a natural tendency to believe that stocks have a limited amount of growth that they can see over a certain period, with this growth being tempered by whatever is assumed to determine a stock’s value.
Stocks are thought to have a certain objective value and the analyst’s task is to decide whether the prices that they are trading at are undervaluing or overvaluing them. The presumption is that they will move from where they are now toward their assessed value and positions are recommended and taken based upon these views.
When you have a situation such as what we have with the impressive performance of stocks in the chip sector, where they are moving up twice as fast as your average stock, this definitely takes us to the realm of overvalued, and fundamental analysts would therefore expect some sort of reversion.
This is presumed to be the case from their price outpacing their earnings growth, where a given dividend is going to become diluted and thus less attractive. All we need to complete this recipe is to add in the fact that this is the sole reason why people buy and hold stocks, to capture dividends, and if this were true, this view would make perfect sense.
All other things being equal, if the price goes down, the dividend rate will rise, and if you’re out to capture dividends, this means that the stock has more value. Conversely, if the stock’s price rises and the dividend remains the same, the dividend yield will go down and this will make the stock less attractive.
One of the assumptions, the one that dividend yields are what drive all the interest in stocks, and exclusively determine their prices, does not correspond with reality at all, and we know that there are other factors that contribute to stock prices besides this. Dividend yields don’t even influence stock prices very much at all generally, and the only type that this does even play a meaningful role in is stocks that pay the highest dividends, high enough that this does attract a lot of dividend seekers, like certain utility stocks.
Otherwise, what drives people to invest in stocks is capital appreciation. Companies will spend a lot of their free cash on buying back stock rather than paying it out to their shareholders, and shareholders like this because it drives up the price of their stocks and this is what the people want, even more than cash in their pocket now.
The 40% Is Really What Matters Here
Chip stocks have appreciated in value twice as much as the average stock this year, and you can bet that people who have held chip stocks over this time are plenty happy about getting a 40% return in a little over half a year. When we compare this with getting an extra 2% on their money from a dividend, this shows why capital appreciation is the real brass ring here.
Since the goal is to sell at higher prices, we do see situations where a faster move up may be followed by some sort of correction, although calling it a correction assumes the dividend model and that’s not what becomes corrected. People do become more tempted to cash in their chips after a good run though, and this can and often does change the dynamic between supply and demand of a stock by increasing the supply more.
Technical analysts, on the other hand, understand the pricing of stocks in a manner that is in harmony with what is perhaps the most basic and fundamental principle of economics, that the price of something is determined by the interplay between its supply and demand. This applies to anything of value that is being exchanged and certainly applies to stock pricing with its unusually efficient markets.
We can see that, with chip stocks, as well as with stocks in general this year, the demand side has been winning and pushing supply back as we move upwards. The factors that influence supply and demand are varied, but whatever is increasing supply and demand and therefore price doesn’t even matter, because it is the fact that this is happening that matters.
If you bought a stock for $100 at the start of the year and it is now worth $140, your position has increased by this much and this is an objective fact that does not require justification or even explanation. We can attempt to explain these things, but ultimately, we have been on a course upward and if this is continuing, and if this is all we are paying attention to, this will keep us in the position as long as its performance suits us.
Fundamental analysts also try to predict the future, with various degrees of success, and sometimes fundamental data can be helpful in doing that if our analysis is valid. Technical analysts are looking to predict the future as well but nowhere near so far ahead and only on the basis of measuring price.
You could therefore show a chart to both types of analysts, and the fundamental analyst would want to know everything they could about the company and wouldn’t even pay much attention to the chart, if any. The technical analyst would just use the chart and wouldn’t even need to know the name of the company because the chart will tell the whole story.
We might think that we need both, but thinking this presumes that the future predictions that the fundamental analyst will try to make are meaningful. If, for instance, it’s decided that price will start to go down in a year or two, that’s not even useful information because we are not even there yet and can just wait until then to decide.
The technical analyst will not act upon these things but wait to see if these predictions are true or not and see whatever ends up unfolding. A simple example of this would be with people selling because they think this all can’t go on forever, versus watching how long it does go on and getting out when price and not prognostications tell us it is time.
Sometimes technical analysts can forget themselves a bit and try to use their tools in the way that a fundamental analyst would, to try to make predictions before they are warranted. You actually see this a fair bit actually when people look at past patterns and make recommendations before the situation has had a chance to play out.
Sometimes these predictions may be based upon correlations with past patterns, and sometimes we may try to be intuitive here, seeing charts that have been moving up and seeing them more at risk of reversing. Even if we have a correlation though, we still need to know whether this will be one of the 6 times out of 10 where we pull back, for instance, or one of the 4 times that we keep going for a while at least.
Analyst Believes This Great Performance is Overdone
Jonathan Krinsky, a technical analyst with Bay Crest Partners, is telling us that he feels that the move with chip stocks may indicate that we should consider pulling back or pulling out, which works out to a similar rationale that people have had about stocks in general given how far we’ve come since 2009.
Technical analysts have a variety of charting tools at their disposal, and the ones that they select to use as well as how they use them to understand what is happening with charts does vary quite a bit. Krinsky’s current insights on chip stocks and how he arrives at them is actually pretty well illustrative of how we might use these things to step away from what we should be doing with these tools and look to overextend them.
One of the things that analysts look at a lot is moving averages, and the 50-day simple moving average (MA) is a pretty popular one. While we need to be careful with how we use this indicator, we traditionally use it to determine whether a chart is bullish or bearish based upon its reference to price, where above this is bullish and below it is bearish.
We’re well above this with the chip stocks, indicative of the current run over the last 50 days, which has been upward. This might seem like a pretty good way to decide these things, if not for the lag involved, and the recent action of chip stocks really illustrates this well.
Chips moved down for the entire month of May, but this signal would have had us hanging around for half of the move down. The next entry would have been halfway through the rebound, having us re-enter at about the same place we got out.
This might seem to be a decent outcome at least but there is a distinct V pattern here and the goal needs to be to make money from such a thing, not just break even. This also is indicative of how we want to also account for what is going on beyond the charts, and the mood of the market was decidedly negative in May due to tariff concerns, but turned around in June when we started to get excited about a rate cut.
There are, therefore, other things we wanting to be looking at when we’re trading on this scale, although someone who is trading on a shorter one involving trends of a few days or less doesn’t need to care.
Krinsky is now pointing to the spread with price and the 50, and if nothing else, this is an interesting way to use this indicator. We are currently 14% above the 50, which is what is concerning Krinsky and having him suggest we should consider getting out here.
This idea has the same flaws as a fundamental analyst would make when he or she looks at a higher price to earnings ratio and claim that the stock is overbought. Krinsky is telling us that chips are overbought because they are this much higher than this MA.
We need to look at what being 14% higher means, and it only means that the stock is moving up at a higher rate. We were in a similar place in February, not quite this much higher but an amount fairly close, and we did pull back in March. The pullback was rather small though and we then resumed our upward course in April, where we were much higher than when we had this larger gap a couple of months before.
When we use trendlines to interpret things since, we do see a sharp one down in May, and this often means that we may expect a sharper one as well when things reverse. We did, and this is why there is such a gap with the 50 MA now.
In any case though, we need to answer the question of why this should be seen as a bearish indication. It actually indicates bullishness, for now at least, and the for now part is the most important part of this.
If we use trendlines with the upward movement from January to April, and one in May when we broke this line, and one since the end of May until now, this is the real way to play this chart, or at least one of them that beats the pants off anything we’re going to do with a 50 MA, because it’s just way too slow.
We might think that we need to look at the 50 if we are trading in a manner that we don’t want too many trades over this period, but both approaches provided only 3 trades so far and one simply outperformed the other by a large margin.
This isn’t to suggest that trendlines are the holy grail of technical analysis, as there are a variety of good ways to measure trends, and applying trendlines are often not anywhere near as easy as this chart example provides, but some approaches are simply inferior and using moving averages alone is among the lesser ones for sure.
Trading on this gap doesn’t really make sense either, as we don’t want to be selling on the way up, and will need some sort of breakdown to abandon ship, but we can measure this as well. It has to happen before we can actually do that though.
Editor, MarketReview.com
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