Is the Chip Sector Running Out of Steam?

It's kind of cool to see a well-respected analyst take an axe to his sector recommendations once in a while. It's an increasingly rare brand of intellectual honesty: Rather than defending one's recommendations to the death, why not acknowledge when your picks run out of steam?

Gleacher & Co. analyst Doug Freedman did exactly that today. In a research note emailed to clients, Freedman lowered his opinion of the Philadelphia Semiconductor Index (SOX) as a whole from a "buy" to "hold." Valuation multiples have caught up to Freedman's often above-consensus estimates, so this would be a good time to move your investing dollars elsewhere.

In particular, Freedman is downgrading Cypress Semiconductor (Nasdaq: CY  ) , Atmel (Nasdaq: ATML  ) , and Micrel (Nasdaq: MCRL  ) because the market has already rewarded their investors for every catalyst Gleacher could identify. Intersil (Nasdaq: ISIL  ) also got a haircut, but mostly due to lagging integration of a bunch of recent acquisitions and lax spending controls.

Three of the four specific stocks downgraded beat the market silly in 2010, while Intersil lagged on a full-year basis but delivered an S&P-stomping 32% return in the fourth calendar quarter. In particular, Atmel and Cypress swung for the fences with 2010 returns of 173% and 74%, respectively. Those two chip designers share an exposure to touchscreen controllers, giving them access to the exploding smartphone and tablet computer markets, both of which Freedman warns have met with inappropriate amounts of investor enthusiasm.

One analyst opinion does not make for an end-all definition of a sector's health, but Freedman is one of the good analyst eggs in my book and I tend to respect his opinion more than most. For what it's worth, all of these stocks still trend toward "buy" ratings on average according to Yahoo! Finance, and Atmel is the only one not carrying at least a four-star rating in our CAPS community.