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

The major indices got off to a weak start yesterday morning, but support of the hourly uptrend lines in the S&P and Dow helped the broad market to rebound by mid-day. Continued relative strength in the tech arena pushed the Nasdaq higher, but relative weakness in several industries held the other main indexes down. The Nasdaq Composite gained 0.6%, the Dow Jones Industrial Average edged 0.1% higher, and the S&P 500 was unchanged. The small-cap Russell 2000 and S&P Midcap 400 indices were lower by 0.4% and 0.1% respectively. Most of the broad-based indexes settled near their intraday highs.

Turnover was basically on par with the previous day's levels. Total volume in the NYSE declined 2%, while volume in the Nasdaq was flat. Given that the S&P 500 was only unchanged, it's positive that trading activity failed to tick higher. However, higher volume in the Nasdaq would have helped to confirm the gains in that exchange. Like the closing prices, market internals were mixed. In the NYSE, declining volume marginally exceeded declining volume. Total volume in the Nasdaq outpaced declining volume by just under 2 to 1.

Over the past five days, the main stock market indexes have been in a relatively tight, sideways range, but substantial "behind the scenes" moves have been taking place within specific industry sectors. This is primarily because mutual funds, pension funds, and other institutions have bylaws that require most of their assets to be invested in the stock market at all times. As such, they obviously put their buying power into the sectors and indexes they feel have the best chance of price appreciation. Conversely, they liquidate holdings they feel have limited chance of going higher. This constant movement of funds out of one sector and into another is known as institutional sector rotation, and is the reason why at least one or two sectors will always show relative strength or weakness to the broad market, regardless of what type of trend the major indices are involved in. Sectors with relative strength can generate double digit percentage gains, even while the S&P and Nasdaq are unchanged.

Sectors and indexes with relative strength rise at a higher percentage than the broad-based indexes in uptrends, while they also fall less than the major indices in periods of downward price movement. If a sector is so strong that it simply moves sideways while the broad market is moving lower, what do you think happens when the major indices eventually bounce? It will usually be the first sector to shoot to a new high. If a new downtrend suddenly starts, the sector with relative strength will also be the last to fall. These are the ones we want to buy because not only is the upside profit potential greater, the downside risk is also lower.

In confirmed broad-market downtrends, we inversely want to be positioned short in ETFs with the most relative weakness to the broad market. They will be the last ones to rise when the market does, and will also fall at a greater pace than the major indices, thereby yielding greater profit potential.

The first step of sector trading ETFs is creating a daily watchlist of the main industry sector indexes, which enables you to quickly spot the indexes that are showing the most divergence (relative strength) to the broad market. The quickest way to do this is by sorting the list of industry sectors by percentage change. Below is a screenshot of our sector watchlist, sorted by daily percentage change. Because this screenshot was taken outside of market hours, notice that some of the sectors are showing unchanged, but that is obviously not the case during the regular session:

If looking for sectors with bullish trend divergence, pay attention to how each index acts whenever the S&P or Nasdaq makes a move. Sectors with relative strength will usually go sideways to slightly higher when the S&P or Nasdaq drops, but will rocket to new highs on the slightest bounce in the broad market. Conversely, short candidates should barely lift off their lows when the S&P and Nasdaq rallies, and should fall to new lows on any broad market weakness.

Upon getting in the habit of scanning your sector watchlist daily, you will quickly learn to spot divergent prices patterns in the broad market. Within the sector indexes, we then want to buy the specific sector ETFs with the most bullish divergence (relative strength) and/or short those with the most bearish divergence (relative weakness) to the broad market. To easily see a list of ETFs within each sector, we suggest downloading the free Morpheus ETF Roundup, then looking up the applicable sector.

The best way to catch divergent trends in the early stages is to become disciplined at scanning your watchlist at a regular interval, depending on the type of trader you are. If you are looking for trades with a three to five day time horizon, for example, you would want to scan for sector trend divergence on a daily basis. But traders looking to enter trades with a one to three month time horizon would benefit more from doing scans that show weekly relative strength of the sectors instead of daily. The frequency with which to look for divergent trends depends on what type of trader you are. Daytraders may prefer to follow the percentage changes on an intraday basis, while longer-term trend traders (such as the Morpheus Capital hedge fund) will look for relative strength on an end-of-day or weekly basis. Regardless of the time horizon you trade, the concept works the same. However, greater trend divergence that results in larger profit potential will obviously come from the longer time periods. When you spot these divergent trends early enough, you can enter the trade, then simply trail stops to maximize your profits as long as the relative strength remains intact.

One final note regarding the screenshot above is the column labeled "% range." In addition to simply plotting percentage price changes, we also like to see where each sector index closed the week (or day) relative to its range of that time interval. The closer each index closed to the top of its range, the more relative strength it is showing. Conversely, indexes that close near the bottom of their ranges are showing the most relative weakness. After getting in the habit of scanning all your sector indexes at a regular interval which you determine, the divergent trends will become apparent. If the same indexes are showing bullish or bearish divergence every time you do your research, a longer-term trend divergence that occurs from institutional sector rotation is probably taking place. Buying the sector ETFs with bullish trend divergence and shorting those with bearish divergence enables you to ride along on the coat tails of institutions who also realize the benefits of sector trading with ETFs. To learn more about this strategy, keep an eye out for my brand new book on ETF trading, scheduled to be published by Bloomberg Press in early 2008.

Open ETF positions:

Long - IBB, LQD
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 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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