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The Technology sector has performed well off its June low, easily outperforming the S&P 500 for the past four weeks. We have read a number of analyst’s opinions suggesting that Technology may evolve into a top performing sector for the months or weeks ahead.

While that is possible, it would be unusual for this late stage of a cyclical bull market. Even more, Technology has not performed especially well relative to the S&P 500 for most of the bull market that started in March, ‘09, except for the initial burst off the August, 2010 low. Also, relative to the NASDAQ 100, Technology has underperformed for the entire bull market.

With this cyclical bull market more than two years old, it would be very unusual for a sector that has not been a meaningful leader, like Technology, to suddenly develop a sustained leadership role. Still, because unusual does not mean impossible, we know what to look for that would indicate the potential for sustained leadership from Technology.

It’s no secret that the Technology sector performs best when it is led by the Semiconductor industry. Semiconductors’ are a higher beta industry within the Technology sector and thus are expected to outperform the sector during uptrends. In addition, because semiconductors are a commodity component in many technology products, investors should expect that any sustained increase in demand for technology products should be led by an increase in semiconductor demand.

With that in mind, we find it interesting that the rally in the Technology ETF (NYSEARCA:XLK) from its June low has been without the participation of Semiconductors (NYSEARCA:SMH). In the chart below (click to enlarge), we illustrate this discrepancy and note the underperformance of the semiconductor index in the bottom panel (red). While Technology (XLK) is near the upper end of its trading range, the Semiconductor ETF (SMH) is still testing the lower end of its trading range. If semiconductor performance improves, it can carry the technology ETF to a new high. However, without stronger semiconductor performance, investors should not expect sustained leadership from Technology.

Technology and Semiconductor index Performance

With earnings season in full swing there are three stocks that have the most weighting in the Semiconductor ETF (SMH) that investors should be focused on; Intel (NASDAQ:INTC), Advanced Micro Devices (NASDAQ:AMD) and Texas Instruments (NASDAQ:TXN). Together, these three stocks comprise about a 52% weighting in the semiconductor ETF. How the market responds to the earnings announcements of these three companies is likely to determine the strength of the semiconductor index and its ability to support the technology sector.

Intel reported earnings Wednesday night and, with lower guidance for next quarter, the market’s response has been tepid. AMD reports earnings on July 21 and Texas Instruments on July 25th. If the semiconductor industry group relative performance is to improve, it should do so commensurate with these earnings announcements. If any of these companies disappoint investors, the ability for semiconductors and technology to lead will be hindered.

Something else worth noting about the Technology sector ETF is displayed in the chart below (click to enlarge). The center panel of the chart displays a smoothed relative performance of Technology vs. the S&P 500. Here, it’s noted that although the sector has performed well short-term, it can be argued that its long-term relative performance is simply in-line with the broad market. In the bottom panel we illustrate surrogates for measuring supply and demand.

At the end of each day, we separate out the Buying and Selling Volume for each of the components of the Technology sector. In green is a measure of the average Buying Volume of all the Technology index components. In red is a measure of the average Selling Volume of all the Technology index components. The message they illustrate is one of caution.


Technology ETF (XLK) with Aggregate Buying & Selling Volume

Average Selling Volume typically begins to rise just before an intermediate trend top in the index, reflecting investor’s initial profit taking and its evolution into full blown liquidation. We can see this at the beginning of the chart as profit taking began slowly in early January, 2010 and quickly increased as the market peaked in April. This repeated in January, 2011 and peaked in March. While Buying Volume has been subdued throughout, the strongest rallies have occurred as Buying Volume is increasing and Selling Volume decreasing. Looking at the period of the past few weeks we can’t help but note that although Selling Volume has declined, so has Buying Volume. In the balance of Supply vs. Demand, the Technology Index has risen over the past few weeks more because fewer investors are willing to sell in front of earnings rather than due to increased Demand. If the Technology sector is to lead on more than just a short-term basis, investors must be willing to buy Technology stocks more aggressively, pushing Buying Volume higher.

The Bottom Line: the recent strength in Technology is encouraging, but may still be just noise and not a renewed uptrend. Because technology performs best when semiconductors are leading, investors should monitor Intel (INTC), Advanced Micro Devices (AMD) and Texas Instruments (TXN) as they report earnings in the days ahead. For the recent strength in the Technology ETF to be sustainable, the relative performance of the Semiconductor (SMH) industry and Buying Volume must improve.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. As a personal rule, I tend to avoid placing new positions ahead of earnings.

Source: The Next Week Can Make or Break the Technology Sector. Here's What to Look For