The PHLX Semiconductor Index (SOX) bounced at strong support on Friday and added to gains in Monday's session, closing back above the 200-day exponential moving average (EMA). Even so, the index has now entered a long-term sell cycle that predicts relative weakness into the third quarter, raising the odds that the pullback from recent highs has just begun. As a result, sector shareholders may wish to lighten exposure on this bounce and consider options protection that is much cheaper this week than last.

Chip stocks have led the upside since the SOX confirmed a historic breakout above multi-decade resistance in the fourth quarter of 2019. Sector returns since December 2018 have been legendary, with the index soaring 86% into the Feb. 14 all-time high at 1,983. Clearly, these gains are unsustainable in the current environment, with the group highly dependent on Asian sales to achieve profitability targets.

Local demand remains the wild card for the group, with American consumers unfazed by tariffs, tsunamis. and other market shocks in the last decade. However, it could be different this time around, with hysteria rising to a level that doesn't match actual infection numbers. More importantly, there's no road map for the outbreak, raising concerns that it will affect consumer and business behavior well into the third quarter.

Chart showing the performance of the PHLX Semiconductor Index (SOX)
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The PHLX Semiconductor Index completed a round trip into the 2000 internet bubble peak at 1,362 in the first quarter of 2018 and eased into a trading range that tested long-term resistance for 21 months before ejecting in to a confirmed breakout in October 2019. The index gained more than 300 points into the January peak at 1,975 and failed a February breakout attempt, carving a small-scale double top pattern.

Last week's breakdown dropped the index below the 200-day EMA for the first time since June 2019, but support at that level has now reasserted itself, generating a strong bounce. Even so, the uptick is already approaching resistance at the double top breakdown, raising the odds for a reversal and secondary downdraft that tests last week's low. There's little evidence that trading floor will hold, exposing additional downside into the 1300s.,

For now, market players should watch the rising trendline in place since the December 2018 low. The February swoon bounced at that support level last week, but a retest at that level would undercut the trendline, raising the odds for a breakdown. While there's no rush for this price action to unfold, we're quickly approaching March triple witching options expiration, which has a well-deserved reputation for high volatility.

Chart showing the share price performance of NVIDIA Corporation (NVDA)
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NVIDIA Corporation (NVDA) has rewarded shareholders with high-percentage gains since June 2019, but the chip giant has just failed a breakout above the October 2018 high, raising the odds for much lower prices in coming months. It reached that peak following a historic uptrend that started in 2015 when bitcoin miners lined up to buy top-end graphics cards. The subsequent advance unfolded in two distinct rally waves, with a sizable correction in the first half of 2017.

The stock plunged more than 40% into the December 2018 low, while the 2019 recovery effort initially stalled in April in the $190s. Bullish price action finally cleared that barrier in October, yielding a 122-point ascent into February's all-time high at $315. The final rally wave mounted the 2018 peak, while last week's sell-off failed the breakout in a high-volume gap, setting off major sell signals.

Look for selling pressure to increase as the bounce approaches $300 and the unfilled gap, which mark high-odds entry points for aggressive short sales. The technical outlook will improve greatly if the upside carries through the top of the gap at $305 because that would reinstate the breakout. However, that bullish outcome would require good news about the outbreak, which seems unlikely at this point.

The Bottom Line

Chip stocks have entered intermediate corrections that could signal lower prices into the third quarter of 2020.

Disclosure: The author held no positions in the aforementioned securities or their derivatives at the time of publication.