Tech Check – XLK

by Dan September 9, 2016 2:19 pm • Trade Ideas

Today’s price action may or may not be the start of a period of greater stock market volatility… I’ll let you know the answer soon enough 😉  But one thing is certain with today’s 2% decline in the S&P 500 (SPX) and the Nasdaq Composite (CCMP), the historically calm Summer that equity investors were treated to is now over. This Summer, we saw a combination of climbing a wall of Brexit worry and a comfort level with the potential for tighter monetary policy in the U.S. that resulted in minuscule daily moves over the past 2 months and historically low levels of realized and implied volatility.

So why the sea of red today? First and foremost we saw an overnight jump in the probability of a September rate increase (currently Fed Funds futures are still only pricing in 32% chance of Sept rate hike) given curious Fed-speak. But I suspect its not just the potential for Fed action, Trump seeing a bump in the polls, putting a little uncertainty back into the November election, to North Korea’s (apparent) nuclear test overnight. All of this adds up to a wake-up call for investors that there is in fact risk while buying stocks at all time highs with the VIX is at historically low levels.

If you have been long and strong I see few reasons to take today’s price action as the sole reason to run for the hills, but I would note that the combination of the weaker than expected August Jobs data, coupled with weak ISM manufacturing and services data in the last week might suggest that the Fed could be tightening into a weakening economy, and might compound the corporate earnings recession that we have been in causing a full blown economic recession. That is at least reason to be careful.

If you think there is a better than 32% probability of that happening, then you might consider protecting gains, or at least defining risk for any new longs.

As far as sectors with particular risk of a quick pullback, one sticks out to me like a sort thumb. Technology could be vulnerable to downside out-performance is today’s selling turned into something more significant. Despite the XLK’s (the S&P Technology Select etf) performance being at the middle of the sector pack, the sector’s 11.5% ytd gains is more than double that of the SPX:

sect

Why the focus on the XLK? Four main reasons:

  1. the largest component, Apple (AAPL) makes up 13% of the etf’s weight, and it is my opinion the stock is not going to trade above the recent highs of $110 for the balance of the year.
  2. without the help of AAPL (down 1.5% ytd), a particular focus will be placed on what I call defensive no growth tech stocks like Microsoft (MSFT), Intel (INTC), Cisco (CSCO), Oracle (ORCL) and IBM which make up almost 30% of the weight. All would be very vulnerable in a cyclical downturn.
  3. then you have AT&T (T) and Verizon (VZ) that make up 10% of the weight, up 16% and 12.5% respectively, largely a result of investors reach for yield (4.8% and 4.44% dividend yields respectively).  If rising rate assumptions prove to be correct, these two stocks could be very vulnerable to selling… and
  4. and of course Facebook (FB) and Alphabet (GOOGL) which make up 17% of the weight, both just off of all time highs.

The etf is concentrated among a handful of stocks, with three of the top 5 holdings (AAPL, MSFT & GOOGL) dramatically under-performing the sector.  Good action on the road, but bad action under the hood.

The one year chart below shows the breakout level from mid July becoming a clear initial downside target at $45:

XLK 1yr chart from Bloomberg
XLK 1yr chart from Bloomberg

And a break below would mean the next target is the long term uptrend near $40:

XLK 5yr chart from Bloomberg
XLK 5yr chart from Bloomberg

I DON’T INITIATE NEW BEARISH TRADES ON DAYS LIKE TODAY, ESPECIALLY AFTER THE LOW VOL PERIOD WE HAVE BEEN IN FOR MORE THAN TWO MONTHS. But, if we were to get a bounce early next week, I like the idea of playing for a pullback in the tech sector, especially this index given the concentration among so few stocks, many that have not kept pace with the broad market and its peers.

So what’s the trade? If inclined to play for a near term re-test of the July breakout, and then lower lows over the next few months, I look for a trade structure that offers a break-even near the breakout level, while offering potential gains back towards key support. I’ll wait for a bounce on Monday or Tuesday, but here are the prices at this moment:

Trade: XLK $46.50 Buy Jan 46 / 40 put spread for $1.30
  • Buy 1 Jan 46 put for 1.75
  • Sell 1 Jan 40 put at 45 cents

Break-even on Jan expiration:

Gains: between 44.70 and 40 make up to 4.70, max gain of 4.70 at 40 or lower

Losses: up to 1.30 between 46 and 44.70 with max loss of 1.30, or 2.7% of etf price

Rationale – This is a defined risk put spread with lots of time that offers a nice risk reward. Ideally I could catch a bounce in the broader market (perhaps to 2160 in the SPX) early next week and get better prices or higher strikes.