"Bear Flag" Chart Pattern On The Dow Industrials

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

Another tug-of-war between the bulls and bears left the major indices flat to modestly lower yesterday. Stocks sold off in the first thirty minutes, reversed to new intraday highs later in the morning, fell to fresh intraday lows at mid-day, then moved back up in the final ninety minutes of trading. Percentage changes in the Nasdaq Composite and Dow Jones Industrial Average were identical with the previous day, respectively at 0.9% lower and unchanged. The S&P 500 ticked just 0.1% lower. The small-cap Russell 2000 fell 0.6% and the S&P Midcap 400 lost 0.5%. Overall, it was another choppy, indecisive day that led to the main stock market indexes closing near the middle of their intraday ranges.

Total volume in the NYSE increased 1%, while volume in the Nasdaq came in 3% lighter than the previous day's level. The marginal 0.1% loss and mere 1% increase in turnover was not enough to label the S&P as having registered another "distribution day." Market internals in both exchanges remained negative. Declining volume in the Nasdaq exceeded advancing volume by just under 3 to 1. The NYSE ratio was only fractionally negative.

The Dow Jones Industrial Average has closed higher or flat in each of the past four sessions. However, the index is now forming a "bear flag" chart pattern on its daily chart. This chart pattern is annotated on the chart below

When a "bear flag" is formed, it usually leads to new lows after the lower boundary support of the flag is broken. A breakdown below yesterday's low would represent such a break of lower boundary support, increasing the odds of another leg down in the Dow. Further, support of the 50-day MA also converges with the formation of the "bear flag." Therefore, follow-through in the Dow "bear flag" would also coincide with a simultaneous break of the 50-day MA. If the Dow breaks below yesterday's low and its 50-day MA, we will likely initiate a new short position. This would be best accomplished through buying the inversely correlated, leveraged UltraShort Dow 30 ProShares (DXD) on a breakout above yesterday's high. The S&P 500 has a similar chart pattern, one that presents a decent short entry below yesterday's low (or above the high on the UltraShort S&P ProShares (SDS)).

Two days ago, the former relative strength we observed in the Nasdaq began to fade. The biggest reason was the collapse in the Semiconductor Index ($SOX), which firmly broke below its 200-day moving average after its fourth test of support in the past three months. Though a 200-day MA always provides very powerful support or resistance, each subsequent test of the support increases the chances of an eventual breakdown below it. Looking at the daily chart of the $SOX below, notice how it was the fifth test of the 200-day MA that finally "broke the camel's back:"

The longer-term weekly chart below shows the $SOX is now testing support of its 52-week low. Just as a breakout to a new 52-week high is bullish and generally leads to much higher prices, a breakdown to a new 52-week low often leads to much lower prices:

Even if not trading in the Semiconductor ETFs, it is important to continually observe the price action in the sector because the $SOX Index is so heavily weighted within the Nasdaq. Rarely will the Nasdaq continue to rally while the $SOX is in a downtrend. Prior to a few days ago, relative strength in biotech and other tech sectors helped the Nasdaq to ignore the sideways action in the semis, but that doesn't seem to be the case now that the $SOX has convincingly broken down below its 200-day MA. Continue watching the price action in the $SOX as a proxy and leading indicator for the direction of the Nasdaq.

Open ETF positions:

Long - UNG, TLT, TWM

Short - (none, though TWM is a bearish position)

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 e-mail alerts are also sent 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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