Networking Stocks: Ready To Short?

As we head into first quarter earnings season, institutional managers are becoming more risk averse – with allocations to speculative stocks (technology and small-caps specifically) drying up.
 
You can see the evidence, pulling up a chart of the iShares Russell 2000 Index (IWM).
 
The small caps ETF failed after breaking to a new high midway through March, and the chart pattern is now flirting with full-fledged technical breakdown.
 
Using traditional technology proxies, the warning signs are more difficult to pick up on. The Powershares QQQ Trust (QQQ) and even the SPDR Technology ETF (XLK) are both within a few daily trading ranges of their 52-week highs. But digging into the composition of these ETFs explains most of the technology strength away.
 
How so? Because both QQQ and XLK have an enormous concentration in Apple Corp. (AAPL). Apple represents a full 17.5% of QQQ, and nearly 20% of XLK. So the strength in this largely consumer-driven momentum stock represents the prominent driving force behind the positive price action in these two technology ETFs.
 
Networkers Breaking Lower
 
The networking sub-sector is looking particularly vulnerable with a number of key components running into overhead resistance. The more speculative names in the group appear prone to a sharp selloff.
 
Analysts are ratcheting down projections for the Q1 earnings season, and while it is still early, disappointments from the likes of Google Inc. (GOOG) and Intel Corp. (INTC) are having an effect on the group.

Expectations for corporate technology spending were at one point relatively high, as investors and managers embraced the idea of a “stable” economic recovery.
 
But the March jobs report – along with disappointing corporate results – introduces more doubt into the recovery scenario. Weakened outlooks for corporate technology spending have already affected investor sentiment for networking companies.
 
For example: Take a look at the weekly chart for Brocade Communication Systems (BRCD):

In BRCD the bullish trend from the second half of 2011 is now clearly broken, as speculative capital looks for a more “stable” home. Mature networking names like Cisco (CSCO) confirm with breakdown chart patterns and price submergence below the 50 day exponential moving average – giving both swing traders and longer-term investors a rationale to lighten up on longs (or enter shorts).
 
F5 Networks (FFIV) represents one of the more “growth intensive” names in the group – and the company reported after the close yesterday (4/18). FFIV’s Q2 report (fiscal year ends Sept 30) will have a material effect on networking stocks – and we’re already seeing weakness as managers trim their positions ahead of the report.
 
The sub-group has a pretty diverse range of valuations / growth expectations (note table below), but the chart patterns are similar in that all names are experiencing distribution and could be high quality short candidates as we pick out attractive entries with reasonable risk points.

We have pending short setups for QLogic Corp. (QLGC) and Brocade Comuniations (BRCD) which will trigger entry on a downside break of multi-day consolidation.
 
Once this minor consolidation area is broken, these names could trade down meaningfully before hitting any material support. Yesterday’s report from FFIV could furthermore be an acceleration catalyst – sending the group lower as managers once again reduce exposure.

There is certainly potential for the networkers to gap sharply lower at the open later today – which is why we prefer to use stop limit orders on our pending entries (to protect against poor fills on the open).

The best trades typically work quickly once they are triggered, so we will be managing our bearish exposure to the group carefully to begin with – requiring follow through action for us to stay involved on the short side.

Disclosure: This content is general info only, not to be taken as investment advice. Click here for disclaimer