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To Monitor Tech Sector Health, Watch Just One Stock

Chad Karnes

"Don't judge a book by its cover", the popular phrase goes. The basic message is that one must look beyond just the surface to discover truth.  This is especially good advice when looking at sector exchange-traded funds (ETFs).

The Technology sector has lagged the broader S&P 500 since the November 2012 lows, up only 4% versus an S&P's gain of 10%.  We all know about Apple's demise which is a big reason for the lagging, but there is also more going on behind the scenes beyond just Apple.

The Large Technology Sector As of March the Technology Select Sector SPDR (XLK - News) made up over 18% of the S&P 500 by market weight.  It's the largest sector by market cap, ahead of Financials at 16%.  A summary of those sector weightings is best captured in the pie chart from SPDR (SPY - News). 

A True Example of the 80/20 Rule

Most investors are aware of the immense size of Apple (AAPL - News) in the Technology sector with 18% of the sector's weighting (as of early March), but this weight has come down from its peak in 2012 of over 20%. 

As of March, the S&P 500's Technology sector is made up of 82 companies and weighted based on market cap (stock price x shares outstanding).  However, just the top 10 technology companies out of the entire 82 make up a full 65% of the XLK's market cap, a true example of the 80/20 rule.  Beyond Apple there are four other companies that make up the bulk of the index. 

Those 5 stocks constitute 45% of XLK and just 3 stocks make up 32% of the XLK's value.  Investors can follow just these key technology companies to help decipher the fate of the tech sector indices.

The spreadsheet captures the breakdown of the technology sector by market cap weighting of the top 10 companies in the index.

45% of Movement Comes from Just 5 Companies

The chart below shows the top five index constituents that make up 45% of XLK's weight and displays the vast difference in performance among these five technology companies.  XLK as a whole is up 3.9%, but its constituents are all over the place. 

Since the November lows, one of the top companies in the sector, Google (GOOG - News) which makes up 7% of the sector's weighting and shown in black at the top of the chart below, has far outpaced the other technology companies, peaking at a 22% gain and lifting the index (also shown in black in the middle) up since November.  IBM (IBM - News) in green and AT&T (NYSE:T) in gold, are also leaders, although not near to the extent as Google was up through its March price peak. 

But, Google has now shifted from a leader to a laggard and is bringing the index down with it (more on that below). 

Microsoft (MSFT - News) and the infamous Apple have also dragged the index down, underperforming their index by 7 percentage points and 30 percentage points, respectively.

With such a large concentration of holdings in such a short list of companies, investors only really need to focus their attention on these top five companies to account for almost half of the index's movement. 

Even more so, as the leader to the upside of the group, following Google gives the most bang for the buck when it comes to forecasting the Tech Index. 

Leaders Lead and Laggards Lag

Leaders lead the sectors to new highs while laggards lead to new lows.  This is why in articles written on 8/17/12 and 9/26/12 we showed how the Financial (XLF - News) and Energy (XLE - News) sectors were the key to the market's rally because of their leadership.  We alerted our subscribers on 7/21 in our August Newsletter how these sectors led the market higher since the June lows and how they would also lead to the downside if/when that trend change occurred. 

"Their underperformance and breakdown in early May (2012) helped identify the market's change in trend from up to down then, and we are expecting a similar event at the market's next juncture. Until these sectors break down, the market's top likely is not in place."

The energy sector is now lagging the market, but the financials maintain their strength, keeping the uptrend alive, for now.

Technology also joined them as a leader as far back as the 2009 lows, that is, until October, when Apple and the rest of the index broke down and became market laggards. 

After 9 months since last summer's price lows, the Financial sector is the only leader still leading.  Are the Technology and Energy sectors trying to tell us something?  If the Financials breakdown, where will leadership come from next?

When Leaders Become Laggards

In the recently released ETF Technical Forecast published twice a week and outlined in this article, an update on the Nasdaq 100 ETF (QQQ - News) was provided to subscribers with the warning that a head and shoulders topping pattern may be forming.  "A break of this level (reserved for subscribers) will also be a long term short signal as it confirms the H&S pattern.  We will cross that bridge if/when it occurs."  Since then the QQQ has managed to double top at its September price high as it continues to lag the other markets. 

The Technology sector already is displaying relative weakness.  If one of its leading constituents, such as Google, joins Apple in relative weakness that would be a major warning sign to us the technology indexes and broader markets may be rolling over. 

Google is Now the Most Important Tech Company

Following just Google in the months ahead will likely tell us what we need to know concerning the Technology ETFs and likely the broader markets as a whole.  When leaders become laggards, it is often a sign of a trend change. 

In a recent Technical Forecast we released 3/31 when Google was trading around $800, we identified a bearish technical divergence occurring as well as two key support levels to watch for a breakdown in that company's share price.  Google has since fallen over 5% from its highs and is very close to confirming a trend change to down.  If this occurs, it is likely a major warning sign for the technology indices and broader markets.

The ETF Profit Strategy Newsletter uses relative strength analysis along with common sense technical analysis to provide a short, mid, and long-term forecast along with actionable buy/sell recommendations.  This helps us identify key trend changes in the sectors as well as the broader markets.

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