This is how investors should respond to the fresh pressure facing chipmakers

Published Mon, Jul 24 20233:10 PM EDT

The generative artificial intelligence boom has seen semiconductor stocks soar this year, no more so than Club holding Nvidia (NVDA). But with chip companies now losing steam with the market rally broadening beyond tech firms, we're doubling down on patience before adding to our semi names. The AI craze has contributed to an extreme imbalance between supply and demand for corners of the semiconductor industry, with Nvidia a key beneficiary given its unrivaled chips used for applications like OpenAI's ChatGPT. That has us optimistic going into the company's next earnings report, on Aug. 23. But Nvidia stock, which has surged more than 200% since the start of the year, has come down around 6% over the past week. The Club's other semiconductor holding, Advanced Micro Devices (AMD), has fallen around 5% during the same period. We're more cautious on AMD going into its earnings print on Aug. 1, as it doesn't have the same outsized exposure to generative AI technology as Nvidia. Both stocks have come under pressure since Taiwan Semiconductor Manufacturing Company (TSM) – which manufactures chips for Nvidia, AMD and others, making it somewhat of a bellwether for the industry – reported earnings last week, highlighting weaker demand and some ongoing inventory challenges amid a softer global economy. "Due to persistent weaker overall macroeconomic conditions, slower-than-expected demand recovery in China, and overall softer end market demand conditions, customers are more cautious and intend to further control their inventory into" the fourth quarter, the company said. The semiconductor industry has been hampered by an inventory glut in the wake of the Covid-19 pandemic that has weighed on revenues — a headwind we had expected would recede sooner. Even so, TSM said its backend packaging capacity for AI-related orders is "very tight" and that it's proving "very hard to fulfill 100% of what customers needed" on the AI front. "Moving into third quarter 2023, while we have recently observed an increase in AI-related demand, it is not enough to offset the overall cyclicality of our business," TSM said last week. That essentially means that chip makers that rely on TSM for manufacturing aren't seeing the demand needed outside of generative AI to drive material order growth. And that dynamic is resulting in a more cautious outlook for the remainder of the year. This divergence between the tight capacity TSM is realizing in regard to AI-related orders and overall demand weakness shows that generative AI growth is exploding — namely, benefiting Nvidia — while demand more broadly has yet to catch up with supply in the rest of the chip sector. Similarly, in a research note Monday, analysts at JMP Securities said that while "demand around generative AI remains extremely robust," elsewhere enterprise IT budgets remain constrained. One venture capitalist reportedly told the analysts that enterprise companies are now willing to pay roughly 30% of the initial costs of IT deals negotiated with software firms. Indeed, companies are optimizing technology spending right now in an effort to keep costs down, while concentrating on only the most mission-critical projects. Ultimately, the semiconductor landscape is highly mixed — which is precisely what's driving our caution at this moment. Semiconductor firms are either basking in the glory of generative AI demand, or working through excess inventory and IT budget-optimization dynamics. Regarding IT budgets, earnings this week from software firms like Club holding Microsoft (MSFT) and ServiceNow (NOW) should provide some insight around enterprise technology spending. And when the semiconductor firms report next month, investors will have a clearer sense on inventory challenges. Nvidia faces high expectations from investors when it reports, following a jaw-dropping beat and raise in May. As for AMD, we need a bit more clarity on its AI efforts and timing around inventory normalization before becoming more bullish on the firm. For the moment, at least, we're maintaining a 2 rating on both our chip names, meaning we'd need to see a bigger pullback before potentially adding to our positions. (Jim Cramer's Charitable Trust is long NVDA, AMD, MSFT. See here for a full list of the stocks.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust's portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . NO FIDUCIARY OBLIGATION OR DUTY EXISTS, OR IS CREATED, BY VIRTUE OF YOUR RECEIPT OF ANY INFORMATION PROVIDED IN CONNECTION WITH THE INVESTING CLUB. NO SPECIFIC OUTCOME OR PROFIT IS GUARANTEED.

The logo of Nvidia Corporation is seen during the annual Computex computer exhibition in Taipei, Taiwan, on May 30, 2017.

Tyrone Siu | Reuters