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Is the Tech ETF Signaling Trouble Ahead?

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Even though equities have been soaring since the beginning of this new fiscal year, the Technology sector seems to be missing out on all the fun. In fact, at a time when the S&P 500 (SPY - Free Report) has been making new highs and posting incredible year-to-date returns of around 9.6%, the Technology Select Sector SPDR ETF (XLK - Free Report) , which tracks the stock market performance of the technology segment in the U.S. equity market, is up by just about 4% (read Four ETFs to Buy on the Market Pullback).

This is an extremely depressing story considering the fact that, heavyweights from the sector account for maximum weighting in the S&P 500 index. This suggests that other corners of the key benchmark are truly carrying the S&P 500, at least for the time being.

Fundamental Headwinds

There are a number of reasons behind this slump though, as key fundamental factors are unfavorable. Currently, many in the tech space are seeing weak overseas demand, overall reduction in global information technology spending, and a strong dollar just to name a few of the headwinds to global tech stocks.

Furthermore, given the present investment scenario, dividend focused investing is well and truly the name of the game. Therefore this has also caused the tech ETF to lag behind as most of the tech companies are not characterized as great dividend payers (see HYLD: Crushing the High Yield ETF Competition).

Technical Weakness

Apart from these broader fundamental headwinds, the tech ETF XLK is also showing technical weakness as indicated by its long term price charts.

The chart above is a 2 year daily price chart of XLK which shows the indication of a head and shoulders top formation. The formation is an extremely bearish one as it has been witnessed to take shape over the period of the past one year.

Not to mention the fact that the ETF has been facing tremendous pressure of late as it has been witnessing choppy trading since late 2012 onwards. XLK is trading just a tad under its 50 day moving average (blue line). Also, this trendline has been acting as a support for the ETF since the beginning of this year (see Are Short Term Bond ETFs the New Safe Haven?).

What’s Next?

Although it is difficult to argue whether a concrete breakout below the 50 DMA line will occur or not, the odds are surely for it. The head and shoulder top formation can definitely not be ruled out as the present choppiness coupled with weakness relative to the broader market surely point towards an imminent downslide.

Also bearing testimony to the fact that the sector is facing weakness lies in the Relative Strength Index (RSI) chart which has been hovering near neutral territory with a slight bullish bias since the beginning of 2013 (red highlighted rectangle).

However, the silver lining for the ETF is that the breakout below the blue line is not characterized by high volumes. Furthermore, the neckline of the top formation is near the $27 mark which is also the next support for the fund. A breakout below this line will surely result in extreme bearish forces taking over the ETF.

Bottom Line

While it is true that fundamental as well as the technical factors point towards the negative side for the technology sector, investors must still note that there is a chance of a turnaround for the sector with the help of a major catalyst — earnings. However, this assumption makes more sense when the longer term picture is taken into account, rather than the short term (read 3 ETF Strategies for the Second Quarter).

Also, considering the technical aspects, a head and shoulders breakout can only be ascertained if the neckline is broken down. Till such time, it is an assumption, however strong the arguments are.

Still, the ETF has a choppy outlook, given its past weakness is most likely to continue on the earnings as well as stock market performance. XLK has a Zacks ETF Rank of 3 or Hold with a Medium risk outlook so be careful trading this fund with key earnings figures being released in the near future (see more in the Zacks ETF Rank Guide).

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