Contemplating A Position In SOXL? Consider These Pointers

The Direxion Daily Semiconductor 3x Bull Shares ETF (NYSEARCA:SOXL) is a leveraged ETF that seeks to generate "3x" the "daily" performance of the ICE Semiconductor Index (ICESEMI). For the uninitiated, the latter covers 30 of the largest US-listed semi-stocks. If you're contemplating a position in SOXL for the first time, here are a few bullish and bearish points that you should consider.

Points To Consider

Firstly, as an initial disclaimer, we'd like to state that considering the daily reset nature of this product, this ETF should not be pursued by novice buy-and-hold type investors who lack the resources and bandwidth to monitor the market. Rather, SOXL is better suited for seasoned market observers who have shorter time horizons and the requisite mental gymnastics to digest the risks associated with leverage and volatility.

A few investors may be forgiven for thinking that if ICESEMI ends up delivering 10% cumulative returns over three days, SOXL could end up delivering returns of 30% over the same period. That reasoning is inaccurate because returns of over one day are dependent on the "compounded" returns of each trading day, rather than 3x the cumulative returns over three days.

The sequence of gains and losses, or the "path" of the benchmark index over a period of time, also plays a crucial role in driving the end results of SOXL. SOXL typically does well during trending one-way moves, with limited bouts of whipsaws. So much so, during a 5-day winning streak with ICESEMI, one could even generate cumulative returns of over 3x with SOXL during the said period.

The volatility narrative associated with SOXL should not be underestimated, and I want to reiterate this aspect because structurally, semiconductor stocks are innately just a very volatile bunch. The image below gives you a sense of the annualized standard deviation of the continuously compounded returns of various unlevered sector ETFs. As you can infer from the image below, on average, these benchmark portfolios have an annualized volatility quotient of 30%, but the semiconductor portfolio's volatility quotient is 1100 bps higher than average; in fact, only the Biotech portfolio has a higher volatility quotient than the semiconductor segment.

Imagine you have a prolonged period of choppy price movements where the semi-benchmark is all over the place and ends up delivering flat returns over one year. Well with an unlevered product, one doesn't have to fret about the level of wealth destruction, but as noted in the image below, with SOXL, given a 40% volatility profile, you could well be looking at negative returns within a range of -17% to -53%!

So, we know that semi-portfolios are inherently highly volatile, but compounding the issue you have a scenario now where volatility in the broader markets has gone up by 20% this month. As you can see from the image below, the VIX, which gives you a sense of "expected" 30-day volatility of the US market, has started trending up recently, after weeks of subdued movement. Think about how unfavorably this would translate to the high-beta semi-segment. Given that the markets have recently been enveloped with a higher dose of volatility, it is questionable if investors should be jumping into SOXL at this juncture, even if the near-term technical narratives around the benchmark suggest that the bulls have the edge.

Nonetheless, the image below shows developments on the daily price chart of the iShares Semiconductor ETF (SOXX), the unlevered semi-ETF which tracks the ICESEMI. Bullish conditions are validated by the fact we saw the 50-day moving average cross the 100-day moving average (the golden cross) in early Jan, and the ETF still continues to trade above both key moving averages, reflecting the confidence of the bulls.

Meanwhile, on the larger time frame, we can see that the descending channel which had germinated in late 2021 is no longer in play. Last week we also saw a bullish engulfing candle, just below a crucial pivot point, taking out the narrow-bodied candles seen in the three preceding weeks. This too bodes well for the bulls.

Whilst the technical conditions look encouraging, fundamentally there are still a few question marks with this segment. After witnessing 1% growth last year, global semi-revenue is poised to decline by 4.4% in FY23. Besides, the upcoming Q1 quarter has historically been a weak quarter for the industry and this year's Q1 is expected to be even worse with nine non-memory semi-entities guiding for a double-digit decline in weighted average sales.

It's also fair to say that the inventory position in the system still needs to be addressed. For context, the table below highlights how most of the top-10 stocks (aggregate weight of ~63%) of SOXL's benchmark index are still struggling to convert their inventories to sales. Except for Texas Instruments (TXN), AMD (AMD), and KLA Corp. (KLAC), all the other top 10 names have turnover ratios that are below their averages. Until the inventory turns in the industry start trending up, investors shouldn't be too enthusiastic about the prospect of higher FCFs (free cash flow).

Rotational players may also question if semi-stocks offer great rotational value at this price point. The image below shows that semi-stocks as a function of the S&P500 are quite overbought, trading above the mid-point of the long-term range.

Finally, there's also the earnings and valuation trade-off. According to YCharts, the constituents of SOXX trade at a weighted average forward P/E of 18.49x, a slight premium to the corresponding multiple of the S&P 500 (18.39x). Yet the semi-portfolio only offers long-term earnings growth potential of less than 10% whilst the constituents of the benchmark offer weighted average earnings growth of 13%. (Source: YCharts).