2023-11-13 07:28:08 ET
Summary
- TECL's most recent upside, which started on October 26, could continue.
- This bullish position is based on its relationship with XLK and the strength of the tech sector.
- However, TECL is highly leveraged, making it suitable for short-term tactical investments.
- Also, next week's economic calendar implies a high degree of volatility.
Since I last wrote about Technology Select Sector SPDR® Fund ETF (XLK) on October 23 , the ETF has gone up by 9.38%, but my forecast was for a 15% upside which means that if I am right, there is still room for further appreciation.
Now, for those who did not invest earlier on but still want to benefit, this thesis aims to highlight a trading opportunity, but, this time, using the Direxion Daily Technology Bull 3x Shares ETF (TECL) whose share price of $55 is still below its July 18 high of nearly $60.
To justify an upside, I will first show the Direxion ETF's relationship with XLK before supporting the bullish case using the cash positions of its holdings at a time when interest rates remain high, using a somewhat similar approach to my previous thesis on the SPDR ETF. Additionally, I will emphasize earnings strength.
The relationship between XLK and TECL
As shown in the table below, XLK holds some of the world's largest publicly listed companies mostly covering products developed through the use of internet-based applications. It also includes service-oriented and IT consulting stocks with giant names like Microsoft (MSFT) and Apple (AAPL). As such, it tracks the Technology Select Sector Index which also provides exposure to semiconductor equipment, as well as computers and peripherals with big names like Nvidia (NVDA), Broadcom (AVGO), and Cisco (CSCO).
Exploring the relationship, TECL also tracks the Technology Select Sector Index which means that it provides the same exposure as XLK, but by an accelerated pace of three times.
TECL and XLK Holdings (www.direxion.com)
This means that studying XLK's performance can be useful to obtain an idea of where TECL is heading. This is further exemplified in the introductory chart where both ETFs have delivered positive gains with the Direxion's leveraged fund appreciating by 28.9%, which is about three times XLK's 9.38%. However, traders are reminded that such a performance is not always the case due to the compounding effect, resulting in losses related to a highly leveraged ETF's path fluctuating significantly within the trading period.
Risks associated with Highly Leveraged ETFs
An example is the period from August 1 to November 11 when, as shown in the chart below, there was a high degree of fluctuation in TECL's share price. On this occasion, TECL not only failed to deliver gains of three times XLK's 0.5% upside, or 1.5%, but it also suffered from a downside of 4.76%. This is the reason why the fund managers state that "there is no guarantee the funds will achieve their stated investment objectives". They also clearly highlight that the returns of 300% of the benchmark index are sought for a single day.
In other words, the trade should be monitored daily for the intended returns, and in cases losses mount, one should be prepared to exit with a stop loss. To minimize the probability of such losses, it is advisable to trade over a shorter duration, unless you are using TECL tactically for hedging against short positions as part of your portfolio. Still, it is important to bear in mind that, at above $179, XLK is currently trading well above its January low of $124-$125, and that adding leverage to a portfolio may not provide that extra boost to enhance gains, as during a turnaround period.
Comparing Price Performances (www.seekingalpha.com)
Looking at the price action, XLK was trading at $179.52 on Friday, November 10, or less than one dollar below its July 18 high of $180.26. While it has gained 37% in one year, its path has been quite volatile as it fell to a low of $160.16 on October 25. Therefore, the ETF has been trading in a range of about $160 (support) to $180 (resistance), with its latest upside starting on October 26 as depicted by the green arrow below.
Looking at the Price Action and Earnings
Now, the main reason for this price action was that 92% of tech stocks that had reported earnings by that time had beaten expectations, which was higher than for sectors like healthcare (90%) financials (70%), and materials (75%). One big tech name was Microsoft, whose earnings for the first quarter of 2024 (ending in September) beat estimates by 12.85% when financial results were announced on October 24. On top, its earnings (diluted per share) of $2.99 increased by 27% YoY.
However, the market did not seem to pay attention as sentiment had already turned negative earlier on because of the following reasons. Firstly, there was the ongoing Israel-Hamas conflict posing geopolitical uncertainty, and, second, the 10-year treasury yield hit the 5% mark for the first time since July 2007 amid a sell-off in bonds. Third, retail sales data pointed to customers disposing of higher disposable income, and, combined with commentaries emanating from the Federal Reserve hinted at interest rates being kept higher for longer in order to address the inflation issue.
In addition, two members of the "Magnificent 7" club suffered from investors' wrath. These were Meta Platforms ( META ) due to cautious commentary as to the future of its advertising business, and Alphabet (GOOG) (GOOGL) because of disappointing cloud performance.
However, these two do not form part of XLK's holdings.
In this case, looking at XLK's main holding Apple, despite its revenue of $89.5 billion representing a 1% year-over-year decline in its fiscal 2023 fourth quarter (which ended September 30), earnings of $1.46, were up by 13% YoY. Continuing on a positive note, its EPS estimates for the current quarter ending in December currently stand at $2.09, or an 11.4% YoY growth.
Moving down the list of holdings, Microsoft's EPS estimates for its current quarter again ending in December are estimated to be $2.75, or an 18.67% YoY growth. As for Nvidia, earnings of $3.37 estimated for the quarter ending in October represent a 481% YoY growth. Looking at Broadcom, the EPS of $10.95 for the quarter ending in October represents a 4.83% YoY growth, while Adobe's (ADBE) EPS of $ 4.14 for the quarter ending in November represents a 14.93% YoY increase.
Now, combined together, these five stocks represent about 60% of the Technology Select Sector Index's market capitalization as tabled below.
Table Built using data from (www.seekingalpha.com)
Therefore, with their capacity to deliver continuous earnings growth, tech deserves better, but other factors are also at play here.
Tech's Appeal Compared to Other Sectors
One of them is adverse comments from the Federal Reserve, especially on Thursday when Chairman Jerome Powell said policymakers are not convinced that interest rates are high enough to bring inflation back to the U.S. central bank's 2% target. He also reiterated that the fight to restore price stability still has a long way to go, while a slowdown in the economy could result in more "disinflation".
However, looking through the noise, Mr. Powell's comments were no different than during the most recent FOMC meeting on November 1 , when the Fed held interest rates on hold, leading many market participants to assume that the rate-hiking cycle had ended.
Looking further, the combined effect of higher interest rates, tightening of lending standards by U.S. banks, and consumer confidence also dropping for the third consecutive month may increase the likelihood of a recession. In such circumstances, investors normally take cover in cash. However, to be realistic, recession talks for 2023 have surfaced since last year itself while during the first two quarters, real GDP grew by above 2% , and is expected to be 4.9% in the third one.
Consequently, with economists, even those from the Fed , not being accurate about when a recession will occur, an appropriate strategy for those wishing to remain invested is to select the stocks whose business models generate cash. You can come across a lot of these in the financial, real estate, and utilities sectors. However, it is important not to forget the March banking turmoil which illustrated how higher interest rates could devalue banks' treasury bond assets. Tellingly, the S&P 500 financial sector index has not yet recovered as charted below.
Furthermore, as dividend payers, stocks from real estate and utilities are more dependent on how monetary policy will eventually play in 2024 when it comes to funding capital expenses. As for energy, certain stocks pay hefty distributions to shareholders, but the high volatility as per the above green chart with a one-year performance of -11.4% shows that investors may be more prone to capital destruction in the future.
TECL's Upside should Continue but amid Volatility
In such circumstances, with their huge cash piles as per the chart below, and historical ability to deliver on capital appreciation, tech remains a viable option.
Cash and Equivalents - Quarterly (www.ycharts.com)
This, in turn, implies that XLK's upside could continue and deliver a further 5.62% (15-9.38) upside, which would translate into gains of nearly 17% (5.62 x 3) for TECL, or a target of $64.35 (55 x 1.17) based on its current share price of $55. Such an upside is also supported by momentum indicators with the stock price being well above the 10-day, 50-day, and 100-day moving averages.
However, this upside could be delayed to next week given that next week's economic agenda includes key CPI data for October and the November 17 deadline for federal government funding, while not forgetting the speeches of Fed officials containing rate-related information. Therefore, brace for volatility, and, and remember that this ETF comes with relatively higher fees of 0.97%.
In conclusion, by going through its relationship with XLK, this thesis has shown that TECL's upside which started on October 26 could continue, but, it is vital to bear in mind that leveraged ETFs are designed for short-term trading. Avoiding a long-term approach is further supported by the SEC or Security and Exchange Commission which warns investors against treating leveraged ETFs in the same way as Buy-and-Hold passive funds.
For further details see:
TECL ETF: The Upside Should Continue, Amid Volatility