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NOTE: Please click on the charts below to enlarge them if they do not appear clearly.

One day after closing at new multi-month highs, the major indices sold off sharply, closing below their previous day's lows. After trending steadily south throughout the session, the S&P 500 and Nasdaq Composite both finished 1.8% lower. Aided by resistance of its 200-day moving average that we pointed out yesterday, the Dow Jones Industrial Average fell 1.6%. The small-cap Russell 2000 and S&P Midcap 400 lost 1.9% and 1.2% respectively. Opposite of the previous day, all the major indices closed near their intraday lows.

Turnover rose in both exchanges, indicating selling activity on the part of mutual funds, hedge funds, and other institutions. Total volume in the NYSE increased 4% above the previous day's level, while volume in the Nasdaq rose 7%. The losses on higher volume caused both the S&P 500 and Nasdaq Composite to register a bearish "distribution day." The NYSE has had four distribution days within the past four weeks, while the Nasdaq has flashed just two days of higher volume selling. When the running count of distribution days in either exchange exceeds four or more within a four-week period, it is often an accurate warning sign that the market is about to pullback substantially. Ugly market internals coincided with the higher volume selling. In both the NYSE and Nasdaq, declining volume trounced advancing volume by a margin of approximately 5 to 1. This tells us the selling was broad-based, not confined to just a few industries.

On Tuesday, the main stock market indexes demonstrated bullish action by opening below their intraday lows of the preceding two days, then reversing to close at their highest levels since mid-January. Yesterday, stocks followed up with rather bearish action by selling off to close below Tuesday's intraday lows. Clearly, the past two days have kept both the bulls and bears on their toes, but the bears may finally be regaining the upper hand. Market internals and price action among leading stocks was more negative yesterday than it was positive on Tuesday. Nevertheless, if you've been paying attention to our recent broad market analysis, yesterday's sudden show of weakness should not have come as a surprise. With the main stock market indexes at or near key resistance of both their long-term downtrend lines from the October 2007 highs and their 200-day moving averages, odds were favoring a significant downside move more than a continuation of the rally, at least in the near-term.

Yesterday's sell-off caused the S&P 500, Nasdaq Composite, and Dow Jones Industrial Average to each break support of its hourly uptrend line that began with the last major "swing low" of April 15. This indicates a shift in the balance of power from the bulls to the bears. The S&P 500 breakdown below support of its hourly uptrend line is shown on the hourly chart below. Remember that the prior uptrend line (the red ascending line) will now act as new resistance on any rally attempt:

Over the next week, we could expect the stock market to show further weakness on the back of yesterday's break of support in the major indices. However, the broad-based stock market indexes still have numerous areas of price support below. The S&P 500, for example, closed below support of its short-term 10-day moving average for the first time since April 15, but support of the more significant 20 and 50-day moving averages is still fully intact. Further, the S&P 500 will soon run into the lower boundary support of its intermediate-term uptrending channel off the March lows. On the daily chart of the S&P 500 below, the beige line is the 20-day exponential moving average and the teal line is the 50-day moving average. We've also drawn the upper and lower boundaries of the current uptrending channel (the blue ascending lines):

It's too early to confidently call the top of the intermediate-term countertrend bounce off the March lows, as we've yet to see how the major indices will act when they test support of their 20 and 50-day moving averages below. Still, it's safe to say the near-term bias now favors the bears. Yesterday afternoon, we bought the UltraShort Dow 30 ProShares (DXD), which moves in the opposite direction of the Dow. It's already showing a decent unrealized gain, and we expect it to move higher in the near-term. Depending on market action, we may add another bearish position in the coming days, but we're using discipline and patience to make sure we don't get ahead of ourselves without having an abundance of price confirmation.

We believe stocks will eventually retest their March lows and put in a more significant bottom before moving much higher, but it could take a while before that happens. The seven-week old rally provided astute traders with profitable opportunities on the buy side of the market, but the current levels of key price resistance also afforded traders the chance to enter new short positions at low-risk prices. The simple fact remains that the charts have shown us nothing more than a substantial countertrend bounce within the context of a primary bear market. Trading what you see, not what you think is a great way to ensure you're always on the correct side of the market. Above all, when in doubt, stay out!

Open ETF positions:


Long - DXD, UUP

Short - (none)

NOTE: Regular subscribers to The Wagner Daily receive daily updates on the open positions above, as well as new ETF trade setups, including trigger, stop, and target prices. Intraday Trade Alerts are also sent via e-mail and/or mobile phone text message on as-needed basis.

Deron Wagner is the head trader of Morpheus Capital Hedge Fund and founder of Morpheus Trading Group (morpheustrading.com), which he launched in 2001. Wagner appears on his best-selling video, Sector Trading Strategies (Marketplace Books, June 2002), and is co-author of both The Long-Term Day Trader (Career Press, April 2000) and The After-Hours Trader (McGraw Hill, August 2000). Past television appearances include CNBC, ABC, and Yahoo! FinanceVision. He is also a frequent guest speaker at various trading and financial conferences around the world. Wagner is currently working on this third book, scheduled for publication in early 2008.

For a free trial to the full version of The Wagner Daily above, which includes detailed ETF trade setups and daily position updates, or to learn about our other newsletters, visit morpheustrading.com or send an e-mail to deron@morpheustrading.com.

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