Another "beware semiconductors" post.

I have liberally lifted from a professional investment letter.

We are in probably the best market ever for semiconductor stocks, so a premium to the last 15 years is, of course, merited. But this good idea has been taken too far. Investors seem to have forgotten that semiconductors are one of the most cyclical products in our economy.

The challenge with bubbles is not that they overstate the ultimate transformative benefits of a technology but rather that they price in many of those uncertain transformative benefits as if they are a given today. As a result, valuations expand, with much of the present value of equities embedding discounted cash flows far into the future, where they are clouded in uncertainty.

In this sub, most of us should care about this. It is not about the absolute valuation but what that valuation IMPLIES about the future. We all like to use DCFs as a baseline. What is happening right now is that more and more of the current value of the semiconductor companies are imbedded in the terminal value, or how the business will perform 10+ years from now.

The global semiconductor industry currently trades at ~55x P/E in aggregate. Instead of asking what the industry should trade at, we can turn the question on its head: What does a 55x multiple imply about future expectations? Courtesy of Michael Mauboussin and Alfred Rappaport’s Expectations Investing framework (ask your neighborhood LLM about it), at 55x we can infer the following:

Roughly 75% of the current value of the global semiconductor industry (13% of global market cap and ~17% of US market cap) is derived from cash flow projections that are more than 10 years in the future (after first compounding at 16.5% for 10 years [this is from the newsletter, not my math]). A decade ago, OpenAI and Anthropic didn’t even exist. Who is to say what the world will look like in another 10 years? Consider some hypotheticals:

• Perhaps AI will design new semiconductors and chips for itself, making the current generation of spend obsolete faster than expected. * Perhaps the race for semiconductors will force enterprising entrepreneurs to come up with clever innovations that invalidate existing supply chains and bottlenecks. * Perhaps software improvements will dramatically reduce the compute required for training and inference of new models. * Perhaps Chinese open-source models will eat away at the competitive advantage of large frontier models in the US, without all the massive compute spend. * Perhaps San Francisco will be hit by the “Big One” and much of the world's AI talent will fall into the sea. * Perhaps datacenters in space will solve everything.

Most of these outcomes may be unlikely, but that is beside the point. The point is that current valuations embed a certainty that the world will unfold according to the most rosy projections that analysts can conjure for an exciting new technology, precisely at a time when uncertainty is highest.

Tech spending is so massive right now, its sensitivity to an economic downturn has been dramatically increased. Any hiccup in interest rates or the global economy (eg. a geopolitical conflict perhaps?) will cause the capital spending to slow dramatically which will have a negative effect on semiconductor multiples the likes of which we have never seen.