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Technology ETFs: Pain or Gain Ahead?

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The technology sector has seen terrible trading over the past few weeks on growing concerns over valuation and future earnings growth. In fact, the tech-heavy Nasdaq Composite Index fell about 8.5% from the record high reached in early March.
Some of the favorite names in the Internet and social media corner of the broad tech space like Facebook (FB), Netflix (NFLX), Twitter (TWTR), Yahoo (YHOO), Amazon (AMZN) and Google (GOOGL) plummeted double digits over the past month. This also resulted in horrendous trading for the tech ETF world.
Global X Social Media Index ETF (SOCL - Free Report) is down 15% while PowerShares Nasdaq Internet Portfolio (PNQI - Free Report) and First Trust Dow Jones Internet Index (FDN - Free Report) are off over 12%. This suggests that more pain might be ahead for tech stocks and ETFs tracking the space, and that investors are increasingly worried about another tech bubble similar to what we saw in the early 2000’s (read: Sell-Off in Social Media Stocks Puts SOCL ETF in Trouble).
Valuation Still Far Shy of Year 2000 Levels
The tech bubble is still unlikely, as the Nasdaq Composite Index appears inexpensive compared to the lofty days of late 1999 or early 2000. According to various studies and sources, the index currently trades around 35 times reported earnings of the companies in it.
This valuation is double the P/E ratio of 17 times for the S&P 500 Index signaling more downside in the near term. Even then, this is much below the astonishing level of 152 times reached at the end of 1999, suggesting that the bubble might not burst this year.
Earnings Growth Expectation
As per the Zacks Earnings Trends, total earnings for the S&P 500 tech companies for Q1 are expected to be down 4.2% while revenues will likely grow 1.6% from the year-ago period. Harsh winter is probably the culprit of the weak earnings growth (see: all the Technology ETFs here).
Though Q1 earnings growth expectation is disappointing, growth of 9.5% in Q2 is reassuring on higher revenue forecast of 4.7%. This is much higher than the earnings growth of 5.4% on 2% increase in revenues for the S&P 500 for the same quarter.
What Lies Ahead?
While Chinese slowdown, renewed tensions in Ukraine and persistently low inflation in the U.S. continue to weigh on investors sentiment, the gradually improving U.S. economy and strengthening job market would provide some support to the stock market rally. And if the market rises, tech stocks will likely be huge beneficiaries (read: Buy These 2 Tech ETFs on NASDAQ Sell-Off).
Despite the slide, the outlook for the whole sector is quite encouraging. The tech sector and the related ETFs are continuously outpacing the broad market index and the fund by wide margins over the past six months. This trend will likely continue, as improving macro fundamentals would propel the stocks higher. Overseas demand is improving, global IT spending is rising while the dollar is firming.
According to Gartner's new Worldwide IT Spending Forecast, global IT spending would increase 3.2% this year thanks to higher enterprise software and device sales. Global spending on enterprise software and devices, including PCs, mobile phones and tablets, are expected to grow 6.9% and 4.4%, respectively. Other corners of the technology space – data center systems and telecom services – will likely see a rise in spending by 2.3% and 1.3%, respectively.
This is especially true given that the two ultra-popular tech funds – Select Sector SPDR Technology ETF (XLK - Free Report) and Vanguard Information Technology ETF (VGT - Free Report) – have been able to withstand the heavy sell-off in the sector, losing around 0.8% and 2.7% in the same period.
Further, most of the ETFs in this space have a favorable Zacks ETF Rank, indicating that they have room for upside as we head into Q2. In particular, the worst performers – SOCL, PNQI and FDN – have a top Zacks ETF Rank of ‘1’ or ‘2’, indicating outperformance in the coming months (read: Top Ranked Technology ETF in Focus: QTEC).
If this is not enough, investors could easily look into technical charts, which indicate a bullish scenario for these ETFs. Let’s dig into this in greater detail below:
Technical Look
In the chart below, we have considered XLK, which provides diversified exposure to the broad technology sector of the U.S. equity market. The fund made its 52-week high of $36.93 on the third day of trading this month and is currently trading at a discount of 46% from the record high reached in early 2000.
Its short-term moving averages have managed to stay above long-term levels amid the broad sell-off. This is because the 9-Day EMA is comfortably above the longer-term 200-Day EMA, suggesting optimism for this ETF.

Additionally, the fund is trading above its support level of $28.76 reached a year ago, indicating that the bearish trend might be far away for this fund. This is further confirmed by the fund’s RSI, which is near 40.
This suggests that XLK is slowly approaching to the oversold territory and has room for a strong run up in its prices in the coming months, especially when tech companies start to show strong earnings and investor sentiment reverses.
Bottom Line
Given the encouraging outlook but somewhat bearish near-term sentiments, investors may want to consider staying on the sidelines for the time being. However, risk tolerant long-term investors may want to consider this recent slump as a buying opportunity, should they have the patience for extreme volatility and a belief that the tech sector can rebound strongly from here.
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