This is the most enthusiasm I’ve ever seen in stock markets. Not from the size of the rally, but rather because the indices are setting all-time highs in the face of the toughest economic conditions ever. We still have 20 million people unemployed, if not more. Yet Wall Street is blindly buying tech ETFs in droves. The equity markets have already recovered in a “v” and more. The government aide packages are hiding the deep wounds that still exist in our economy. Just this morning, Congress passed the extension of the Paycheck Protection Program.
Much of the risk appetite is favoring high risk momentum stocks. These are companies whose products and services serve the new world order of digital delivery and subscription models. Some of the ones making new highs are Peloton (NASDAQ:PTON), Zoom Video (NASDAQ:ZM) and even the older gurus like Salesforce (NYSE:CRM). The Nasdaq recovered best out of the quarantine crash, and in fact it has already set all-time-highs this morning with no let-up in sight.
The bulls are tag-teaming MVP’s, so they sell one group to rotate into another. For a while they chase mega-cap tech like Apple (NASDAQ:AAPL), Facebook (NASDAQ:FB) and Netflix (NASDAQ:NFLX). Then on other days when they sell those, they roll their profits into frothier tickers like ZM and Roku (NASDAQ:ROKU).
I am usually optimistic about the stock markets, but I have serious worries these days. Last year, I wrote about buying every dip stemming from the China trade war headlines. This is different because the U.S. went from full employment last year to maximum unemployment this year. The economic reports may look fine, but the wound from the quarantine is bleeding internally. This is not evident while the government is spending trillions of dollars supporting the deficit. The election season will pass and the politicians will lose interest in quantitative easing programs.
Caution is warranted while markets behave like it’s 1999. Investors should fade this extreme exuberance in the Nasdaq using the following three exchange-traded funds. I feel a little guilty for my negative tone, but in my defense, I suggested going long on the April 21 dip. Back then, it served as the base for this incredible 25% rally in these tech ETFs:
- Invesco QQQ Trust (NASDAQ:QQQ)
- VanEck Vectors Semiconductor ETF (NASDAQ:SMH)
- Technology Select Sector SPDR Fund (NYSEARCA:XLK)
I will start by sharing my order of preference on these bearish bets. Out of these three tech ETFs, the SMH seems the weakest because it has the most lower-highs in the last two weeks. Then the XLK because it has at least one recent failed breakout. Finally, only the QQQ is in open space and has no recent fails since it just made new highs.
Tech ETFs to Trade: Invesco QQQ Trust (QQQ)
The QQQ is the main Nasdaq ETF that traders most often use. It is heavily concentrated with the top dogs and they are the great American companies led by Microsoft (NASDAQ:MSFT), Apple, Amazon (NASDAQ:AMZN), Facebook and Alphabet (NASDAQ:GOOG, NASDAQ:GOOGL). The top five make up almost half of the the entire basket. The call today is to fade the rally into the Fall season. Placing a bearish bet on the QQQ stock is simple when using options. Shorting the stock outright is too risky because it opens unlimited risk for as long as the rally continues.
I realize that doing this now is going against the grain because it suggests fighting the Federal Reserve and the tape. Using options, investors can buy a long-term debit put spread to capture at least a 10% correction. This is a directional position that needs a drop to profit and time is its enemy. At the close of yesterday, traders could buy the December $242 / $232 debit put spread for $3 debit. This is the maximum potential loss per contract. To win, the QQQ has to fall ideally through both legs. The maximum upside potential is then $7 per contract. Those who have a bigger risk appetite can buy the $232 put naked for a cost of $12.80 per contract. In this runaway market that’s a big ask.
To lower or eliminate the entry cost, an alternative method is sell bear call spreads, which would leave room for error. The advantage here is that profits can come without a correction. All it needs to win is that the QQQ not rally more than 10% from here. For example, the December $280 / $285 credit call spread could pay $1.50 per contract. The advantage of this is that the price can rally and it can still win.
Technology Select Sector SPDR Fund (XLK)
The XLK is another popular tech ETF and it is also heavily weighted with Microsoft and Apple, which make up more than 40% of it. But the XLK is also heavily influenced by Fintech. Visa (NYSE:V), MasterCard (NYSE:MA) and PayPal (NASDAQ:PYPL) to name three make up almost 15% of it. This complicates matters a little bit for the bears because they would be shorting two different hot concepts. Wall Street is not only in love with tech, but they are almost even more enamored with Financial Tech. PYPL stock rallied 115% off the Covid-19 low and is now miles above its prior highs. This is a good illustration of my concern.
I understand the concept of momentum trading very well, but I usually prefer chasing a specific breakout. In this case, the bids are system wide and investors are buying whatever regardless of thesis. Investing is not that easy and there will be pain for many. The first step is to avoid chasing into such froth, and placing a few bearish bets makes sense. Both concepts here are over extended, so they are vulnerable to hiccups.
Again, here the easy method is to buy some downside scenarios in the put options out until the end of the year. Placing shorter-term bets could pay quicker but then time becomes a worse liability. The XLK stock is just as exposed as the QQQ, so it comes down to a matter of taste. I find it easier to manage my trade with the QQQ than this one.
The XLK has support through $100 per share, but if they lose it, the bears could try to target another $5 drop. Once again, my call today is not one of doom and gloom, but it would be normal to retrace prices back to the May breakout levels without changing the overall bullish thesis. The bulls can retain control for as long as they maintain the higher-low trend. Meaning, I would buy the dips when they come.
VanEck Vectors Semiconductor ETF (SMH)
Another concept that investors are loving this year are chip stocks and they are best represented by the SMH. This tech ETF is heavily weighted by Taiwan Semiconductor (NYSE:TSM), Intel (NASDAQ:INTC) and Nvidia (NASDAQ:NVDA). These three account for almost 30% of the fund. I am a big fan of Intel and Nvidia stock and I wrote about buying every dip in them. Like the XLK, SMH’s chart has support just below current levels and a pivot zone at $142 per share. The bulls will defend the zone vigorously because they are an emotional bunch over these stocks. To short the SMH from relative safety, buy the Nov $130 / $120 debit put spread for under $2 per contract. This is a reasonably priced opportunity to capitalize on a correction this Fall.
As noted earlier, these ideas go against the grain when it comes to tech ETFs. In addition, the Nasdaq is going into a seasonally bullish period. Although, I don’t usually trade hype like this, it is important to acknowledge that this is yet another reason why shorting this insane rally caries unusual risk. The methods discussed today use finite potential, so they are not reckless. There are dozens of other ways to approach tech ETFs today, but simple vertical put spreads are the easiest to explain and execute.
Nicolas Chahine is the managing director of SellSpreads.com. As of this writing, he did not hold a position in any of the aforementioned securities.