The technology sector is on fire. Potentially blazing out of control as a matter of fact. For the ride higher is being driven largely by momentum at this point. Where and when it stops, nobody knows. But we have entered territory across the sector where the risks to the downside are accumulating at a compounding rate the further the current run continues to the upside.

Blazing Hot

The run higher in technology stocks over the past year has been remarkable. After languishing in a sideways trading pattern for the better part of two years since the end of 2014, technology stocks finally broke out to the upside in early July 2016.

The catalyst for the breakout? This, of course, was the immediate aftermath of the surprise 'Brexit' vote, which raises an initial eyebrow. I am not yet clear how the departure of the United Kingdom (NYSEARCA:EWU) from the European Union (BATS:EZU) is a boon for the prospects of the technology companies found in the S&P 500 Index (NYSEARCA:SPY), but what I do know is that central banker support stood at the ready to calm financial markets in the wake of the vote announcement. And soothe tech investor fears they appeared to achieve!

Tech stocks trended sideways following the July 2016 channel break until the end of the year. Then suddenly, the sector completely caught fire and has been riding a growing wave of upside momentum ever since.

Fundamental Support, But To A Point

At first glance, it appears that the upside in technology stocks is enjoying fundamental support. And to a certain degree, this is true.

Consider the path of the Technology Select Sector SPDR (NYSEARCA:XLK) over the past six years since the summer of 2011. Why the summer of 2011? Because it was at this point during the post crisis period where U.S. stocks (NYSEARCA:DIA) and the rest of the world (NASDAQ:ACWX) including developed international (NYSEARCA:EFA) and emerging market (NYSEARCA:EEM) parted ways with U.S. stocks (NASDAQ:QQQ) continuing to rise to the moon as stocks across the rest of the world effectively have gone nowhere ever since.

Unlike some other market sectors, the rise in technology share prices has been supported by an increase in underlying earnings growth. During periods when earnings growth was accelerating, so too were technology stock prices. And during periods when earnings growth either stalled or showed signs of fading, the advance in technology stocks ground to a halt. Thus, the contention can be made that technology stocks are behaving consistently with the fundamental patterns implied by underlying earnings growth.

This is certainly constructive. But the one problem with this assessment over the past six years is the following. While technology stocks are advancing in correlation with rising earnings, the price that investors are paying for technology stocks is rising at a much faster rate than the underlying earnings. Put more simply, investors have been consistently paying increasingly more for each dollar of earnings growth that the sector is generating. This is reflected in the second chart below where the XLK and underlying sector earnings are placed on the same scale.

This can also be reflected in the following chart, which shows the daily rolling trailing 12-month price-to-earnings ratio on the XLK from July 1, 2011 to the present.

Whereas technology stocks were once priced at an attractive 13x to 15x trailing earnings back in 2011 and were still pricing in the expensive but still somewhat reasonable 17x to 20x range as recently as a year ago, they are now trading in the 25x times trailing earnings range.

Putting this in a different perspective, technology stocks are now offering an earnings yield of roughly 4%. Given the cyclical nature of the industry, this is not a lot of "yield" to receive even in today's persistently low interest rate environment.

Of course, technology stocks can overcome this premium status through an acceleration of underlying growth beyond its already robust +20% pace over the past year. Such a feat is not out of the question, but it is a tall order given the fact that technology is still a highly cyclical sector whose annual earnings growth rate has fluctuated between -10% and +20% at any given point in time over the past six years and is currently running at the very top end of this range coming out of the most recently completed quarter in 2017 Q1. In short, it's possible, but not likely.

Momentous Momentum

This is where the momentum trade comes into play for the technology sector. Over the past six years, the tech sector has evolved initially from an "intrinsic value" theme to more recently a "growth at a reasonable price" to lately a "growth at any price" pursuit.

It has been widely noted how stock market breadth has narrowed in 2017. For example, the percentage of NYSE stocks trading above their 50-day moving average has fallen from a peak of 84% at the start of the year to roughly half of stocks in recent months.

In addition, economic growth forecasts have steadily faded since the start of the year from the enthusiastic growth expectations that initially sparked the markets at the end of last year.

Yet despite this narrowing market leadership and fading economic growth prospects, the S&P 500 Index is still up strongly in 2017. The primary driver of these gains has been the strength of the technology sector. And part of the driving force behind this move has been the sentiment that excess liquidity is looking for a home and that technology is the one sector where investors can still buy growth while also gaining a degree of downside protection. Put more simply, investors have been parking money in tech lately regardless of the price driven by notion that they can continue growing regardless of the economy. Hence the still accelerating upside momentum despite the already impressive run.

This has been a great trade for those that have ridden the upside to this point. My premium service on Seeking Alpha, for one, went long technology stocks via the XLK back in mid-December 2016 as a hedge against a cyclical acceleration in economic growth. But through the end of February after an already impressive run to the upside that pushed the relative strength index to readings above 80, which was an overbought level that had been rarely reached in its two decade history, the decision was made to take profits. Thus, I have been merely a spectator to the sector's latest leg to the upside that began in late April and continues to date, which serves as another important reminder of the powerful upside momentum that remains in today's stock market.

Maintaining Momentum

The challenge for the technology sector going forward is its ability to maintain its recently remarkable upside momentum. One of the primary risks associated with the momentum trade is that it is not necessarily built on fundamentals or even technical for that matter. Instead, it is built primarily on enthusiasm and the willingness of the next buyer to pay more for the right to own shares of the company than the previous buyer. And this all works beautifully for a time until it does not. And the longer the forces of momentum take hold and the longer they run, the more painful the subsequent downside adjustment can end up being.

Such is the primary risk facing the technology sector at this stage of its recent run. The sector itself is expensive and becoming increasingly expensive with each passing trading day. And this is something that is true not only of the sector itself but many of the underlying individual stock names in the XLK.

Consider the following trailing 12-month price-to-earnings ratios for the following notable companies make up roughly 40% of the entire XLK.

Apple (NASDAQ:AAPL)

2011 P/E Ratio: 12.0x

Current P/E Ratio: 18.0x

Google (NASDAQ:GOOG)

2011 P/E Ratio: 21.8x

Current P/E Ratio: 33.7x

Facebook (NASDAQ:FB)

Current P/E Ratio: 38.9x

Microsoft (NASDAQ:MSFT)

2011 P/E Ratio: 14.7x

Current P/E Ratio: 31.9x

Intel (NASDAQ:INTC)

2011 P/E Ratio: 9.7x

Current P/E Ratio: 15.6x

Cisco Systems (NASDAQ:CSCO)

2011 P/E Ratio: 12.7x

Current P/E Ratio: 16.0x

Does value still exist in the technology sector? Perhaps among selected individual names. But at least in so far as the above list is concerned, it would require an acceleration of already robust earnings growth as of late to create this value. And in an environment where the pace of economic growth is fading and the U.S. Federal Reserve is raising interest rates, this is becoming an increasingly tall order.

The Bottom Line

The technology sector has enjoyed a tremendous run to the upside in recent months. But it no longer represents a good buying opportunity for investors with a more conservative to moderate risk tolerance, for the downside risks now outweigh the expected returns at this stage of the rally. In short, the reasonable upside opportunity set in the sector has played itself out long ago now.

Does this mean that the sector is done advancing to the upside? Not by any means, for once a momentum trade takes hold it can run indefinitely and well beyond what might be implied by fundamentals. But the sector is now running increasingly ahead on price of an already heady pace beyond its underlying earnings, thus the associated downside risks with such technology holdings are rising accordingly with each successive gain in price. Thus, selective profit taking in tech holdings may also be a prudent approach depending on your investment strategy and how your technology stock holdings fits into your broader asset allocation.

Is the technology sector then an attractive shorting opportunity? It will be at some point, but not until the upside momentum has been broken. This will be worth watching for in the days and weeks ahead. But if the current market environment has taught investors anything, any future short allocations are better implemented as part of a pair trade to hedge against a broader market that remains determined to advance to the upside no matter what is taking place in the underlying economy.

So while the tech sector that is filled with glamorous, headline grabbing stocks continues to run to the upside, equity investors with a value or "growth at a reasonable price" orientation are better served to look elsewhere at this stage of the rally.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

Disclosure: I/we 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.

Additional disclosure: I am long selected individual stocks as part of a broadly diversified asset allocation strategy.

Originally posted here:

Technology: Momentous Momentum - Seeking Alpha