Semiconductor stocks fell sharply after BofA Merrill Lynch turned bearish on the industry and downgraded several chipmakers, including Intel Corp , citing a modest rise in inventories.

Shares of bellwether Intel fell 6 percent to $19.01. Rival AMD dropped 5 percent to $6.96.

Other chipmakers followed suit: Nvidia dropped 5 percent to $12.87; Micron was down 7 percent at $6.97; and RF Micro was down 5 percent at $4.42. The Philadelphia Semiconductor Index <.SOXX> was down 4 percent at 309.37.

The drag on semiconductor chips pulled down the broader U.S. markets -- the Nasdaq Composite Index <.IXIC> tumbled 1.86 percent, the Dow Jones industrial average <.DJI> slid 1.27 percent and the Standard & Poor's 500 Index <.SPX> fell 1.55 percent.

Chip stocks have been rising since the start of the year. Excluding today's losses, Intel has risen 37 percent this year. AMD has risen 239 percent.

The brokerage said a correction was likely, given the rising levels of inventory in the supply chain.

While we believe the correction will likely prove short and shallow, we think any hint of a correction in the supply chain could punish (semiconductor) stocks, BofA Merrill wrote in a note to clients.

The brokerage downgraded Intel, the world's largest chipmaker, to neutral from buy, and made similar rating changes to rivals LSI Corp , Marvell Technology Group Ltd , Texas Instruments Inc and Dutch chip equipment maker ASML Holding NV .

BofA Merrill also cut its 2010 growth estimate for the sector to 18 percent from 21 percent.

Other downgrades included Microchip Technology Inc , Maxim Integrated Products Inc , National Semiconductor Corp , Power Integrations Inc
and British microchip designer ARM Holdings Plc by a notch each to underperform.

Barring a sharp upturn in the global economy, our indicators point to the potential for an inventory correction, thus rendering the risk-reward associated with ownership of chip stocks unattractive, it added.

In addition, recent indications from the Asia PC supply chain suggest a downward bias to PC build forecasts in the near-term, the brokerage said.

With personal computers accounting for more than 40 percent of overall semiconductor sales, the weakness in the PC supply chain cannot be ignored, BofA Merrill said.

Despite the brokerage's cautious view on the sector, it still expects continued growth in electronic end demand in conjunction with an economic recovery.

Global semiconductor sales in the third quarter rose 19.7 percent sequentially, the Semiconductor Industry Association said earlier this month and forecast an upbeat full-year sales.

Inventory levels are not overly built up, but there might be some adjustments here and there in certain segments, Kaufman Bros analyst Suji De Silva said by phone.

I think demand is more the concern, whether the holiday spending is going to be robust or not, De Silva said. I think people are getting a better sense of the demand picture as you get closer to the holiday season.

Broadpoint Amtech analyst Doug Freedman said there was still a lot of uncertainty in the market. At a period of time when there isn't really a lot of information out there, everyone is trying to figure out, is demand going to be good enough, or will they overshoot on inventory?

(Additional reporting by Tenzin Pema, S. John Tilak in Bangalore; Editing by Anil D'Silva and Saumyadeb Chakrabarty)