The market is still struggling to figure out where the bottom is for semiconductor stocks. Like other tech sectors, semiconductor and semiconductor capital-equipment stocks were supposed to have turned around. Alas, most stocks related to semiconductors have experienced dismal performance this year, with many dipping below the lows set in April and September 2001.

Applied Materials Inc. (AMAT--Nasdaq) is the world's largest maker of semiconductor capital equipment. Given the company's size, its earnings reports are usually a good gauge of the state of the semiconductor industry. Applied Materials is one of the few semiconductor capital equipment companies that produces a tool for almost every step of the manufacturing process. The company is the proverbial 800-pound gorilla: It will use brute force to enter a new market and make life miserable for the existing players. Competitors include KLA-Tencor, Lam Research, Novellus, and Teradyne, plus several Japanese companies.

The semiconductor capital-equipment industry has always been characterized by periods of boom and bust. A cycle begins at the trough with most semiconductor companies suffering from severe overcapacity due to excess supply and lack of demand. Overcapacity disappears as production lines are shut down. Some manufacturers then start to buy leading-edge equipment so they can better compete once demand improves. Demand starts to rise, and as it does, capacity utilization at the semiconductor fabricating plants grows. Orders are for a mix of leading-edge equipment and equipment to increase production volume. Demand for semiconductors continues to increase, and customers start to worry about whether they can get enough. Semiconductor makers then scramble to add capacity, and they often double-order equipment from semiconductor capital-equipment companies. Demand for semiconductors reaches its peak and it looks like the good times are back. But they won't last, because there's now excess capacity. Prices decline significantly, and the mechanics work in reverse until a trough is reached.

Why is this interesting? Semiconductor capital-equipment stocks double, triple, or more in price from the bottom, so catching them at the right time can pay off handsomely, while a poorly timed investment can be devastating.

Most industry observers thought the trough had been reached late last year, as orders were finally starting to rise following several disastrous quarters. But the increasingly murky macroeconomic outlook and the continued lack of IT spending have given many second thoughts about the sustainability of the apparent recovery. Also, early orders might have been due to semiconductor manufacturers no longer being able to postpone maintenance.

Applied Materials reported that its second-quarter revenue was up 26% from the previous quarter. But new orders were below expectations, increasing just 5% from the first quarter. The most interesting part was the outlook. Citing a weak macroeconomic outlook, continued reluctance on the part of businesses to spend on IT, and semiconductor manufacturers' capital-expenditure cuts, Applied Materials forecast that third-quarter revenue would be flat to slightly up, but orders would be down 5% to 15%.

A decline in orders isn't supposed to happen once the industry embarks on a recovery. This means the semiconductor capital equipment industry could face another downturn despite barely having emerged from the current one--or a slow and protracted recovery with possibly more false alarms along the way.

In either case, it's probably too early to buy stocks in this sector. Valuations haven't reached trough levels: They've actually stayed fairly high until recently. This also implies that there might be further downside

in most of these stocks. During the last downturn, several smaller players were trading below the value of the cash on their balance sheet. This time around, valuations never dipped that low. Patience remains a strong virtue, particularly when investing in semiconductor capital-equipment stocks.

William Schaff is chief investment officer at Bay Isle Financial LLC, which manages the InformationWeek 100 Stock Index. reach him at [email protected].