Technology Stocks Worth Consideration At Market Highs

by: Eric Parnell, CFA

The stock market as measured by the benchmark S&P 500 Index finally arrived at a new all-time high on the final day of the first quarter. While this represented a grand accomplishment for those that are bullish on stocks, many investors are understandably trepidatious about either taking the plunge or continuing further in this market after its recently strong run. This is particularly true given the notably shaky fundamental backdrop for the market. But for those risk sensitive investors still seeking opportunities in stocks, the technology sector may still offer some appeal.

So how much further can we expect the stock market (NYSEARCA:SPY) to rise anyway? With the Fed pumping billions of dollars of liquidity daily into the financial system, there is no telling how high the stock market could rise. At its current rate, we could see the S&P 500 cross 2000 by the end of year. Why not? Capital markets are so completely disconnected from reality already, so what is to stop it from tacking on another 440 S&P points before the end of the year? Never mind that the already sluggish rate of economic growth in the U.S. is slowing and many other parts of the world are already mired in recession. Never mind that we are but only one day and one boneheaded policy mistake away from the outbreak of the next financial crisis. Never mind that corporate earnings growth on the S&P 500 has been downwardly revised by -6% over the last year at the same time the Index itself has increased by +11% in price.

Never mind that corporate profit margins have compressed by 150 basis points in recent quarters at the same time the Index itself has risen by over +15%. Never mind that the stock market is already trading at a premium to its historical valuation. Heck, even if the S&P 500 Index hit 2000 on April Fool's Day, it would only be trading with a P/E ratio of 20.65, which of course would still probably be deemed as "significantly undervalued" as one former central bank chairman recently put it. If this were to come to pass, I am most certain we would not lack for analysts to justify the advance and help explain the next leg higher that awaits.

It should be noted, however, that U.S. stocks walked alone to the upside in Q1. While the S&P 500 gained +10% in Q1, developed international stocks as measured by the MSCI EAFE Index (NYSEARCA:EFA) advanced less than +4%. Emerging market stocks as measured by the MSCI Emerging Market (NYSEARCA:EEM) Index fared much worse, declining by nearly -4% for Q1. On the fixed income side, the more stock-like high yield bond (NYSEARCA:HYG) category was the only major category to advance with a modest gain of just over +1%, but the asset class is now extremely overvalued with downside risks that vastly exceed any further upside potential. Municipal bonds (NYSEARCA:MUB) were flat and all other major bond groups were down including core bonds (NYSEARCA:AGG), investment grade corporate bonds (NYSEARCA:LQD), U.S. TIPS (NYSEARCA:TIP) and long-term Treasuries (NYSEARCA:TLT) that were each down between -0% to -3%. And precious metals investors had it worst of all, with gold (NYSEARCA:GLD) and silver (NYSEARCA:SLV) falling -5% and -7%, respectively, for the quarter despite the global monetary printing presses running at full blast.

Thus, if you were not allocated to U.S. stocks, chances are Q1 was a lackluster quarter at best for performance. All of this middling to poor performance outside of U.S. stocks leaves open the possibility, of course, that at any time the liquidity being pumped daily into the financial system may eventually decide to flow away from U.S. stocks and into any number of these other recently ignored or spurned asset classes, but this is a topic for another article.

With all of this being said, investors watching the U.S. stock market rise to new highs are likely searching to capture any remaining opportunities. And at this stage of the rally, the best candidates to explore are those that may have been left behind during the Q1 advance.

The technology sector is a leading candidate in this regard. For while tech stocks and the broader market had been highly correlated in recent periods, they have diverged widely over the past six months. During this time, the stock market as a whole has managed to climb to new heights in recent months, but the technology sector has been mired in a slump and is still trading well below its previous September 2012 peak.

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This fact brings to light what seems like an obvious pair trade opportunity with technology stocks rising to catch up with the broader market and/or the stock market falling to reconnect with the tech sector. But an examination of technology stocks as represented by the Technology Select Sector SPDR (NYSEARCA:XLK) raises some concerns from a technical perspective. This is due to the fact that the sector as a whole shows the signs of a head and shoulders topping pattern. Adding to these concerns are the fact that with each successive peak, both the relative strength and momentum readings have become notably weaker. Given these developing forces, an eventual double-digit break lower in the sector as a whole cannot be ruled out over the remainder of the year.

But this still does not rule out the possibility that selected individual names within the tech sector may have great appeal. As a result, it is worthwhile to explore some of the largest names in the sector, which also happen to be the strongest financially on the most part and may hold up relatively better during a tech sector pullback or a broader market correction. The following are the 10 largest names as a percentage of the XLK:

Apple (NASDAQ:AAPL): 14.42%

International Business Machines (NYSE:IBM): 7.50%

Google (NASDAQ:GOOG): 7.28%

Microsoft (NASDAQ:MSFT): 7.26%

AT&T (NYSE:T): 6.83%

Verizon (NYSE:VZ): 4.78%

Oracle (NASDAQ:ORCL): 4.03%

Qualcomm (NASDAQ:QCOM): 3.91%

Cisco Systems (NASDAQ:CSCO): 3.77%

Intel (NASDAQ:INTC): 3.13%

Although the XLK is comprised of 78 individual names, the top ten positions shown above represent nearly two-thirds, or 63%, of the assets in the entire product.

While an argument could be made for or against any of the ten names shown on the above list, it is preferred that those selected for further consideration have the characteristics of quality (financially healthy), value (trading at a discount to the market and its own historical average valuation) and current income (provides a reasonable dividend). A focus is also placed on emphasizing those stocks that have recently trailed rather than outperformed the market. These characteristics are given priority with the recognition that if the broader market was to fall into correction that these characteristics may not only help these stocks to hold up better, but it also may enable them to rise against the tide.

Four names rise to the top of the list following this screening process: Apple, Oracle, Cisco Systems and Intel. Each stock is worth a closer look.

The plight of Apple is well known over the last six months and is well documented on the pages of Seeking Alpha. After peaking at just over $700 in September 2012, the stock has been in a free fall ever since. And it is Apple, of course, that has been the primary driver of underperformance for the XLK relative to the broader market over this time period, as Apple's stock has declined by -40% from peak to trough. But after bottoming in the $420 range at the beginning of March, it has recently shown renewed signs of life. Over the past month, it has rallied into what has recently been strong resistance at its 50-day moving average. But the stock managed to poke its head above its 50-day this time around for the first time in many months. Moreover, its relative strength also broke meaningfully above 50 and its momentum has been improving with each new successive low in the stock price. All of these factors bode well from a technical perspective, and the stock also has established support in the $420 range. Thus, the stock has well defined entry and exit points at present. From a fundamental perspective, while the company certainly has its competitive challenges ahead, it remains a financially healthy company with mountains of cash and a strong operational track record that is currently trading at 10.3x trailing 12-month earnings. For all of these reasons coupled with the fact that the ongoing hedge fund liquidation in the name may finally be drawing to a close gives this name appeal at present.

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Oracle was a name that was actually leading the market in the recent rally. That was until last week, when the company announced third quarter revenues and earnings that missed expectations. This sent the stock plunging -10% on March 21 alone and down another -4% over the next two trading days. This sharp pullback has set up a particularly attractive entry point to get long Oracle shares. The stock landed on support at its 200-day moving average, which is also currently in the range around $31 per share level that once served as resistance and now provides support. The stock was also trading outside of its lower Bollinger Band on the pullback and moved into technically oversold territory based on both its relative strength and momentum readings. It is worth noting that the last two instances when Oracle reached comparably oversold levels it went on to rally sharply over the next several months. Fundamentally, the company benefits from stable revenue streams and has an impressive long-term track record of revenue and earnings growth as well as margin expansion. And the fact that it is trading at an -18% discount to its historical valuation and an -8% discount to the broader market following its recent pullback only adds to the interest in owning the company at present.

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Intel is another name worthy of consideration. The microprocessor giant offers steady operating results relative to its semiconductor peers and offers a generous 4.2% yield. Moreover, the company trades at just 10.2x trailing 12-month earnings. But the fact that it is a chip company makes it far more economically sensitive in an environment where the course of future global growth remains genuinely uncertain. And from a technical standpoint, although the stock has recently rallied, it has arrived at what is stiff resistance at $22 per share. Moreover, it is returning to these levels with less relative strength and momentum than it enjoyed during its last breakout attempt in January. Thus, either a decisive breakout above $22 or waiting for a pullback into the $19 to $20 range would be preferred before beginning to consider initiating a position in the name.

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Cisco Systems is also a fine company in many respects. Operational results are generally solid despite some choppiness on the margin front in recent years. And the stock now trades at just 12x earnings, which represents a -25% discount to its historical valuation as well as the broader market. The company also now provides a healthy dividend yield of 2.7%. Despite these positives, the company looks like it may be running out of steam from a technical perspective. Although the stock broke out to a new high above $20.81 per share in January, it has been making higher highs on waning relative strength and momentum going back to mid December. And in recent weeks, the stock has been struggling valiantly to hold support in the $20.50 to $20.80 with technical readings that are either about to crossover or already have broken into bearish territory. These forces suggest that further downside may be ahead in the coming weeks for Cisco shares, perhaps a pullback toward the $19 range where it may be more worthwhile for consideration.

The stock market warrants close attention as we move into the second quarter of 2013. While a sharp pullback may occur at any time along the way, it is equally possible U.S. stocks could continue to defy gravity. For this reason, it remains worthwhile to consider where attractive risk-adjusted potential may still exist in the current environment. And the technology sector may be offering some of the best opportunities at present.

Disclosure: I am long AAPL, ORCL, VZ, TLT, TIP, MUB, LQD, AGG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long gold and silver via the Central GoldTrust (NYSEMKT:GTU), the Central Fund of Canada (NYSEMKT:CEF), the Sprott Physical Silver Trust (NYSEARCA:PSLV) and Silver Wheaton (NYSE:SLW).

Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.