Technology Sector: Hidden Signs Of Promise

by: Eric Parnell, CFA

The performance of the technology sector has been particularly poor during the recent market correction. While the stock market as measured by the S&P 500 Index (NYSEARCA:SPY) is still down -5.3% from its mid-September peak, the technology sector as measured by the Technology Select Sector SPDR (NYSEARCA:XLK) has turned in a double to the downside at -10.0% over the same time period. Such dismal performance from the tech sector in recent months raises understandable concerns, particularly since it often leads the broader market and is currently well out in front to the downside. But a closer look under the hood at the technology sector reveals that underlying performance may not be as bad as it seems.

First, it is worthwhile to focus on the technology sector more broadly as measured by the XLK. This exchange-traded product currently consists of the 78 technology stocks found in the S&P 500 Index. But as would be expected, the XLK is not equal weighted. Instead, it is market cap weighted and includes market giant Apple (NASDAQ:AAPL). This one stock alone makes up 19.09% of the XLK, and this is after the stock has shed nearly -20% of its market value since the mid-September peak. As a result, the recent woes specific to Apple have placed tremendous downside pressure on the returns for the XLK.

For this reason, it is worthwhile to take a look at the Technology Select Sector SPDR ex-Apple to see exactly how much pain is being exerted on the index by this single large name. When calculating returns for the XLK with Apple excluded, the returns for the sector are considerably better at -7.5%. And if you were to go one step further and back out Microsoft (NASDAQ:MSFT), which is the third ranking name by market cap weighting in the XLK at 7.26% and has had a comparably lousy -14% run since mid September, the return on the XLK improves even further to -6.8%. Moreover, when examining the XLK on an equal weighted basis, we see that 58% of the component stocks are outperforming the underlying index, 35% are outperforming the broader market as measured by the S&P 500 and 14% are trading in positive territory since the mid-September peak led by Yahoo! (YHOO), which has impressively moved +15.7% higher during this period.

So while the story from the overall technology sector is certainly not without its problems, and it is still underperforming the overall market even when you strip out two of its biggest names in Apple and Microsoft, it is not performing nearly as poorly as its seems on the surface. But when thinking of the tech sector as a leading indicator, it is not the overall tech space that many are tracking. Instead, it is the semiconductor industry, for if companies plan on making any products that are technology related, they first need to order the chips to begin the production process.

Thus, it is also worthwhile to focus on the semiconductor industry specifically. For this purpose, we will examine the performance of the Market Vectors Semiconductor ETF (NYSEARCA:SMH), which includes the 25 largest U.S. listed and publicly traded semiconductor firms. While the SMH has done relatively better than the overall tech sector as measured by the XLK since mid September, its -7.7% returns still also trails the S&P 500 by a solid margin over this period.

But once again it is worthwhile to examine the composition of the SMH, which is also market cap weighted and dominated by chip giant Intel at 18.62% of the total index. And just like Apple and Microsoft, Intel's returns since mid September have been particularly poor at -15.6%.

If one were to examine the performance of the Market Vectors Semiconductor ETF ex-Intel we would see a similar phenomenon that we saw with the XLK after removing Apple and then Microsoft. Overall, the SMH without Intel would have returned -4.1% since mid-September, which is 1.2 percentage points better than the S&P 500 Index over this period. What is perhaps even more notable is the fact that the SMH is up +1% since October 19, and this comes despite the fact that Intel has been down -7% over this same time period. So without Intel, the SMH would have gained +3% over the last month since October 19. Whether Intel is included or excluded from the SMH during this period, it still compares favorably to the S&P 500 Index that is down -3% over this same time period. This is particularly notable, for it is relative outperformance like this from the semiconductor sector that can provide a leading signal

So while the story from the overall technology sector certainly provides understandable cause for concern, upon closer inspection it appears that the recent signals from the tech sector for the broader market may actually be more promising than they seem.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

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