In the heart of a momentous week in the world of central banking, the spotlight gleams brightly upon the US technology sector, with the Technology Select Sector SPDR Fund (NYSE Arca: XLK) looking to continue its year-to-date momentum. All eyes are fixed on the impending announcement from the Federal Reserve regarding its interest rate verdict. This year has been nothing short of exceptional for the tech sector, riding high on the tidal wave of artificial intelligence enthusiasm, propelling industry leaders to unprecedented summits of success. Yet, amid this jubilant journey, looming macroeconomic uncertainties cast their shadows over investors’ minds.
While the prevailing consensus anticipates a pause in the rate hike saga, we must always be prepared for surprises in this unpredictable era. Given the tech sector’s acute sensitivity to fluctuations in interest rates, the watchful gaze is fixed firmly on Jerome Powell’s forthcoming commentary. Within these carefully chosen words, the future growth trajectory of tech giants for the latter part of the year may be unveiled.
Technical
On the 1D chart, a cup and handle formation has emerged atop the uptrend, as a temporary pullback has left the market on the edge of its seats. Currently, the 50-SMA trades above the 25-SMA, suggesting bearish pressure, confirmed by the downside intraday momentum with the price below the daily pivot point of $169.66.
Support at $167.90 held firm in the Monday session, but with the current momentum, a breakdown at this support could see a continuation of the current downtrend toward $166.47 (S2) and $165.18. If the Federal Reserve speaks hawkishly, the longer-term trend could continue toward neckline support at $158.01.
However, should the Federal Reserve speak with a dovish tone following the interest rate decision, the price could pivot off $165.18 or $163.10 if there was downside pressure in the Tuesday session. From there, the prior uptrend could continue with the 25-SMA resistance posing a crucial barrier. If the price moves above this level, breaching resistance at $172.85 (R2) could see a retest at the supply zone where the fund previously faltered, with higher resistance established at $181.31.
Fundamental
During periods of high interest rates, high-growth technology companies tend to be pressured due to the nature of the growth business. With high P/E ratios, investors are betting on future cash flows and pricing in the growth possibilities of the company. XLK operates with a P/E of 27.89, which is quite an elevated multiple, and the higher interest rates could take away the companies’ capacity to reinvest in innovation to unlock that incremental growth. Meagre dividend payouts are another characteristic that takes away the attractiveness of growth stocks due to the opportunity cost of reinvesting these dividends at higher market rates. As a result, investors tend to prefer value stocks in such an environment due to their cash flow generating ability that trickles over into shareholder returns, compared to betting on future cash flows. However, this is not always the case, especially when considering the underlying securities in the XLK fund.
The fund seeks to provide investors with exposure to the technology sector of the S&P 500 index. The top 5 holdings of the fund are shown below, with Apple and Microsoft accounting for 46% of the fund’s allocation. Nvidia and Broadcom account for an additional 9% of the fund’s exposure, with no other security holding a weighting larger than 3%. With both Apple and Microsoft being established in the industry, their interest rate sensitivity could be less than other high-growth startups due to the large cash flows they already generate. However, while the fund has 65 holdings, there is a lot of concentration risk inherent in the single stock movements of Microsoft and Apple, which could drive the fund’s price due to individual single stock developments.
In addition, the top 5 holdings have had a stellar year so far despite the challenging environment, with Nvidia returning 70.91% over the last six months, followed by Adobe and Broadcom with 48.66% and 34.71%. The two largest holdings, Apple and Microsoft, have also performed well over the last six months, returning 14.82% and 17.76%, respectively, outperforming the S&P 500, which returned 13.71%. As a result, the fund has grown by 18.05% since April, with the market entirely buying into tech due to the AI potential in the industry.
Regarding its sector exposure, the fund primarily invests in software companies, with a 38% exposure to this sector, while semiconductors and technology hardware make up another 50% of the allocation. Together, these three sectors account for 88% of the fund’s securities. Within these sectors, Microsoft makes up most of the software division, while Nvidia and Broadcom dominate the semiconductor space.
Unsurprisingly, the semiconductor industry has done well over the last year, returning 46.12%, mainly driven by the surge in Nvidia’s stock. This summarizes the fact that the XLK fund is highly dependent on the movements in its top holdings, to which it is heavily concentrated. The graph below shows how the semiconductor sector has driven the fund’s returns above the other sectors to which it has exposure, as Nvidia and Broadcom’s dominance this year has resulted in large moves in the fund.
Summary
The fund estimates 3-5 year EPS growth of its securities at 12.45% while operating with a dividend yield of 0.91%. The low dividend yield and high valuations (P/E of 27.89 and P/B of 8.98) demonstrate the importance of the interest rate decision on the fund’s performance. However, it only has 65 holdings with a large concentration in Apple and Microsoft, making it vulnerable to single stock risk in those two companies. With support at $167.96 being vulnerable to a breakdown at Tuesday’s open, the price could experience some short-term downside toward $165.18 and $163.10 before reacting to the Federal Reserve’s interest rate decision, where the cup and handle continuation from the uptrend could play out toward $172.85 and $181.31.
Sources: Koyfin, Tradingview, Reuters, State Street Global Advisors
Piece written by Tiaan van Aswegen, Trive Financial Market Analyst
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