XLK: big tech ETF enters high reward/high risk zone as earnings approach

When I do my Monday scan of the Dow 30 stocks, it gives a good feel for the broader market in the only metric I ultimately care about: how much risk am I taking to try to make money. Any stock or ETF can go up in price at any time. But with what amount of major loss potential attached?

To me, that risk management along the way to trying to make sustainable profits is the “other half” most investors have not been trained on. In fact, I think some never do learn it. They should.

XLK is the market, more than ever

And that’s why Technology Select Sector SPDR ETF (XLK) is such a timely ETF right now. Because it has moved past the stage in the technical analysis process where it is a good prospective buy. It is well beyond that. It recently entered the “parabolic” phase, or at least it appears to have. Does that mean it can’t go higher?

No, just the opposite! It can go much higher. But re-read the above if needed, to recall that XLK is one of those ETFs that is now a higher risk situation, and a higher reward situation. The simpler term I use to describe the chart is “stretched.” I’ll cover that shortly, but first let’s recap what XLK is, and why it might be the key to this market.

XLK is one of 11 sector “spider” ETFs created by State Street back in 1998 to track each sector of the S&P 500 separately. And given the dominance of the tech sector during much of that time, it has dwarfed the other 10 sector ETFs in assets. It was a “fair fight” 5 years ago, but that purple line (XLK) has run away and hid, so to speak.

AUM growth of the 11 sector SPDR ETFs. Source: Ycharts.

We saw this same pattern leading up to the dot-com bubble busting in the year 2000. Here’s what happened to XLK back then. It fell by 78%.

XLK total price returns in the dotcom bubble. Source: Ycharts.

But to many, that’s ancient history and no longer relevant, even if it is front-and-center in the minds of us who managed money during that era. That was part of what made me a risk manager, a title I proudly wear still.

XLK today: top-heavy, but is that a bad thing?

XLK is currently what a sports analyst once called the top 3 players on an NBA team: “the Boston 3-party.” Invited to XLK’s 3-party are Nvidia (NVDA), Microsoft (MSFT) and the recently re-invigorated Apple (AAPL). NVDA is the new kid, since we can see from the table below that MSFT and AAPL have been atop XLK’s capitalization-weighted ETF for more than a decade. Each of the 3 is at least twice the size of any other stock, and together they take up more than 40% of the space XLK has to allocate.

XLK top holdings. Source: Barchart.

XLK’s “head of the snake”

That creates a situation where the “head of the snake” is those 3 stocks. The other 60% of XLK’s $82 billion in assets are spread across roughly 70 other stocks. Those 70 would all have to be moving in sync to offset what occurs with the top 3. This is a bug of XLK, but also a feature. It all depends on where traders’ appetites for the US tech sector go in the weeks and months ahead.

And, as great as these big tech stocks are, at some point valuation will matter. That might be years from now (as it was when investors thought stocks were overvalued in 1995, only to see them spike for 5 more years). Or, it might be during this upcoming earnings season.

Because the data presented in this table below can be summarized in a single word: expensive. That is, unless earnings keep plowing ahead AND investors are OK with PE and PS ratios that are well above what many traders would consider even the high end of “normal.”

XLK valuation and growth metrics. Source: Barchart.

Show me the chart!

The daily technical chart is still very much intact. But so stretched out, it is more vulnerable with succeeding moves higher. The 20-day moving average has been spot on as an indicator here, as it often is. It turned up at the start of May, $50 ago.

XLK technicals. Source: Barchart.

And while the PPO momentum indicator at the bottom is what I’d consider “pinned” at the top of its range, that is not a bad sign. Not yet, at least. As long as it doesn’t break down from there, XLK can continue to float on the air of massive flows into tech stocks, and the biggest tech stock ETF, XLK.

XLK: Higher and higher

ROAR Score. Source: Sungarden Investment Publishing (author).

XLK is a case of “higher and higher.” Higher reward, but higher risk than just a month or two ago.