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Why Earnings are Key for the Tech ETF XLK

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As the fourth quarter earnings season gains mileage, the broader markets seems to be poised for a strong surge. This is especially true considering the positive economic developments that have taken shape of late and the surprisingly solid earnings picture put up by corporate America thus far.

The technology sector will be in focus this week as giants like Apple Inc (AAPL - Free Report) , International Business Machines (IBM - Free Report) , and Microsoft (MSFT - Free Report) are all set to announce their quarterly results. The sector has been facing tough times of late with the overall business spending, while consumption for I.T. firms have witnessed a strong decline as well (see Strong Auto Sales: Good News for Metal ETFs?).

This has surely made a dent in investors’ confidence in respect of this sector. As a result, the once reigning tech sector which was leading the broad market rally is actually trailing it by a rather wide margin.

Given this situation, it is imperative for the Tech bellwethers to put up a good show this week to revive the sector. The following one year price chart analysis of the Technology Select Sector SPDR ETF (XLK - Free Report) exhibits mixed results.

The ETF managed to reach its 52 week high of $31.74 last year in September. It was a time when the Technology sector was leading the broad based market rally. However, since then, the ETF has shown signs of weakness.

Also, the recovery post the election sell-off in mid November has been quite disappointing and finally it seems the ETF has entered a choppy trading period (read Diamond ETF: An Investor's Best Friend in 2013?).

Earlier in 2012, the ETF had faced similar headwinds when it remained directionless (with a flavor of bearishness) for a decent period of time (indicated by the bigger rectangle). During that time the Parabolic Stop and Reversal (SAR) did not make much sense either in terms of direction of the technology ETF.

However, then came the second quarter earnings season which was fairly positive for the tech sector as a whole. This acted as a catalyst for an uptrend for the ETF and its prices soared.

Currently we again find ourselves in a similar situation without an indication of a clear cut direction as confirmed by the Parabolic SAR which indicates choppiness (indicated by the smaller rectangle). And this time around also earnings will be the key catalyst that will decide the upward or downward trend for the ETF (read 3 Apple Proof ETFs).

The Relative Strength Index (RSI) also confirms this lack of direction in this ETF as is indicated by its neutral reading (around 50) for quite some time now (highlighted portion).

However both these above mentioned situations are not exactly similar as indicated by the chart below.

Comparison with the Broader Market

The tech sector is highly correlated with the S&P 500 since the giant large caps in the sector get a bulk of the weightings due to the extremely large market capitalizations. With this thought it is imperative to note that the period in question in the bigger rectangle was characterized by a down trend in the S&P 500 as well. Therefore a fair bit of weakness was more or less expected in this ETF.

However in this present choppiness, the case it not the same. Even after the New Year rally, the broader market (i.e. S&P 500) has been able to pick up momentum as indicated by the green circle.

Despite this broader market strength, the Technology ETF has been down trending (as indicated by the red circle). And in an up trending market this clearly is a sign of weakness brewing (see Two Sector ETFs to Buy in 2013).

Speaking of Trends

XLK is currently trading below the 100 DMA (red line) which might act as a strong resistance. Nevertheless, despite the impressive New Year rally, the ETF has severe short term weakness as the 50 DMA (blue) is trending below the 100 and 200 DMA (green) lines.

Bottom Line

The Technology Select Sector SPDR ETF (XLK - Free Report) is surely set for an exciting trading week ahead; however, it is time to focus on the fundamentals for the time being. Any slight ‘higher than expected’ results from the Tech bellwethers are expected to push prices up.

Conversely, a dismal show could well see the ETF plummeting to levels even below the 50 DMA support line. Clearly, earnings hold the directional key for XLK.

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