While chipmakers have enjoyed unprecedented sales over the past two years, with demand far outstripping supply, this year the semiconductor industry has suffered a long-feared reversal. After a rough few months for semiconductor stocks, one Wall Street analyst expects the pain to continue, predicting on Tuesday that "we are entering the worst semiconductor downturn in a decade."

In a note Tuesday, Citi $C Research analyst Christopher Danley wrote that this earnings season was the first since the pandemic began that consensus estimates for the chip sector have declined during earnings. While many analysts attributed the blame to cooling computer and smartphone sales at a time when the specter of recession looms over the economy, others pointed to the continued strength of the auto and industrial sectors as a reason for optimism.

Danley, however, did not see the same positives and said he believes strong sectors are showing signs of future weakness.

"We've seen the first signs of a correction in the automotive and industrial markets and continue to believe we are entering the worst semiconductor downturn in a decade given the recession and inventory build-up," Citi Research analyst Christopher Danley said in a note, referring to order cancellations from automotive and industrial companies posted in recent weeks by executives at Micron Technology Inc $MU and Analog Devices Inc $ADI.

"We expect more companies to announce cancellations from the automotive/industrial end markets because while capacity will be added on the supplier side, demand is weakening," Danley said.

Danley firmly believes the market will factor this into the stock price and expects the SOX index to reach new lows and fall another 25%. The PHLX Semiconductor Sector, which trades under the acronym SOX, is an equity-weighted index composed of the 30 largest U.S. companies primarily engaged in the design, distribution, manufacture and sale of semiconductors.

SOX is already on track for its worst decline in 14 years. For the year, the index is down 34%, and if it stays that way, it would be the index's worst decline since 2008, when it fell 48% for the year. Another 25% drop from its current level of just under 2,700 would push the index to 2,020, a low not seen since July 7, 2020, when it closed at 2,019. SOX last closed at a record high on Dec. 27, when it closed at 4,039.51.

Semiconductor companies focused on the automotive and industrial sectors

Semiconductor designers focused on the automotive and industrial sectors include Texas Instruments Inc $TXN, which has a large presence in automotive chip sales and recently reported an outlook that beat Wall Street estimates at the time. Sales of analog electronics, which convert real data such as sound or temperature into digital data, rose 15% to $3.99 billion from a year ago period, while analysts had forecast $3.66 billion. Sales of embedded processors, which take that digital data and use it to perform specific tasks, rose 5% to $821 million, while analysts expected $740 million. Analog Devices and $ADI Semiconductor Corp. fared similarly. $ON.

Major automotive suppliers outside the U.S. include the Netherlands' NXP Semiconductors NV $NXPI, Japan's Renesas Electronics Corp. and Murata Manufacturing and Germany's Infineon Technologies AG.

What stocks to invest in

Danley's top choice among chip companies is Analog Devices. Analog Devices is a leading manufacturer of analog, mixed-signal, and digital signal processing chips. The company has a significant market share in conversion chips, which are used to convert analog signals to digital and vice versa. The company serves tens of thousands of customers and more than half of its chip sales are to industrial and automotive end markets. Analog Devices' chips are also incorporated into wireless infrastructure equipment.

Besides, he wrote Tuesday that his favorite stocks to own after the downturn are Micron $MU, AMD $AMD, ON Semiconductor Corp. $ON and GlobalFoundries Inc. $GFS. Two of Danley's favorite stocks fall squarely into the automotive and industrial categories: Analog Devices and ON Semi.

DISCLAIMER: All information provided here is for informational purposes only and is in no way an investment recommendation. Always do your own analysis.