Semis could be flashing a warning to the rest of the market

The once-hot chip stocks have fallen out of favor lately, down 15 percent from the recent high and snapping a historic win streak.

That move is flashing a warning sign to the rest of the market, said Charlie Bilello, director of research at Pension Partners.

“Back in May 2016, the SOX index first crosses above its 200-day moving average and then we have this long, long uptrend here and just last week we break below that level,” Bilello told CNBC’s “Trading Nation” on Thursday.

The PHLX Semiconductor SOX index, home to 30 chips stocks, broke below its 200-day moving average on April 24. Before last week, the SOX index had secured 458 consecutive closes above its 200-day, a streak never before seen in the index’s nearly 25-year history.

“That’s something to watch because the semiconductors tend to be a leading indicator for the economy, a leading indicator for the stock market, so you don’t want to see weakness here,” said Bilello.

The semiconductor space, he explains, is typically more economically sensitive than other industries. Given their cyclicality, when the chips stocks do well, it usually follows that the broader economy is doing well, too, he said.

Another interesting pattern is forming in the charts that could give an indication as to where the chips head next.

“You have what’s called a head and shoulders potential here,” said Bilello, pointing to a left shoulder formation in January, a top in mid-March and a right shoulder formation in mid-April.

A head-and-shoulders formation occurs when a high is made, followed by a dip, then a higher market peak, a second dip and then a lower high that fails to reach the top. It can be used to predict when a bullish trend is coming to an end.

The series of lows seen during this head-and-shoulders formation is the key level to watch, said Bilello.

“You don’t want to see a break down below” the bottom of those shoulders, according to Bilello’s charts. “You want to see it stabilize here and push back higher.”

The SOX index hit a year-to-date low of $1,203 during its February sell-off, which marked the end of its first shoulder. Its more recent intraday low on April 25 was $1,223.

After outpacing the S&P 500 since mid-2016, chips’ hot streak is beginning to cool. That is not a major concern to Bilello yet, but could become one if chips continue to break down.

“This year we’re kind of in a sideways pattern and I think that’s OK,” he said. “Semiconductors don’t have to lead the market … but you definitely don’t want to see this, you don’t want to see the semiconductors be a lagging sector.”

These technical factors all boil down to one question that investors should be asking, said Bilello: Why is strength in semiconductors moderating?

“The key question for really the stock market here is what’s going on in the fundamental picture,” said Bilello. “Are stocks looking ahead to weaker earnings next year or are they just digesting last year’s gains?”

The SOX index celebrated back-to-back gains of nearly 40 percent in 2016 and 2017. It has risen just 1 percent so far this year, slower than in years past but better than the almost 2 percent decline by the S&P 500.