Gap Down To Long-term Support?

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

A modest rally attempt promptly fizzled out last Friday morning, sending stocks lower for another session. However, the major indices stabilized at mid-day, helping minimize the losses. The S&P 500 lost 0.6%, the Dow Jones Industrial Average 0.5%, and the Nasdaq Composite 0.3%. The small-cap Russell 2000 fell 1.1%, continuing its slide to another 52-week low. The S&P Midcap 400 closed 0.4% lower. All the main stock market indexes closed in the bottom third of their intraday ranges.

Total volume in the NYSE rose 15%, while volume in the Nasdaq increased 4% above the previous day's level. Last Friday was monthly options expiration day, so it was not surprising to see higher turnover. Still, it was the busiest day of trading in the NYSE since August of last year. Similarly, Nasdaq trading was the highest in several months. Market internals were negative, but not by a wide margin. In both exchanges, declining volume exceeded advancing volume by less than 2 to 1.

As you've probably already heard, markets around the world got slammed while the U.S. markets were closed for Martin Luther King Day. The global selling pressure has, of course, spilled over to the U.S. futures markets as well. As I write this late Monday night, the S&P, Nasdaq, and Dow futures are each positioned to open approximately five percent lower than last Friday's closing prices. Presently, the S&P 500 futures are trading around the 1,267 level. Does that number sound familiar? It should, as we said in last Friday's Wagner Daily that "the S&P 500 crashed through support of its five-year uptrend line. With the long-term uptrend line now broken, the next major area of support should be found around the 1,267 level. This is the 38.2% Fibonacci retracement from the October 2002 low to the October 2007 high." We have applied the Fibonacci retracement lines on the monthly chart of the S&P 500 below:

After the S&P 500 broke support of its five-year uptrend line last week, we expected the downward momentum to continue at least to support of its 38.2% Fibonacci retracement. Nevertheless, we did not necessarily expect that drop to come just two days later! It's certainly too early to tell whether or not the 1,267 area will provide support for long. However, if the market is going to put in a significant bounce sometime this month, this would be the most likely level for it to happen. Looking at long-term charts such as this are a good way to keep things in perspective. Though the S&P 500 is already down nearly ten percent this month and poised to slide five percent more on the open, the reality is that we are merely seeing an overdue correction from the impressive five-year bull run. Only if the 61.8% Fibonacci retracement is violated would stocks be likely to test their 2002 lows.

Like the S&P, the Dow is also positioned to open in the vicinity of its 38.2% Fibonacci retracement of its five-year uptrend. This is shown on the monthly chart of the Dow Jones Industrial Average below:

With the futures down so much in the pre-market, stocks are likely to follow one of two scenarios today. The first is that institutions immediately take advantage of the gap down to 38.2% Fibonacci support and begin heavily buying. If this occurs, new long entries could be made relatively safely by first waiting for the S&P and Nasdaq to rally to new intraday highs after the first twenty minutes of trading. This would likely lead to strength throughout the entire session. The other scenario is that institutions sell heavily into the opening gap down, taking stocks much lower. A breakdown to new intraday lows after the first twenty minutes of trading could lead to panic selling in the market.

As we've been saying for weeks, your main focus in this market must be capital preservation, not huge profits. Successful investors and traders are not those who pick a high percentage of winning stocks in good times, but rather those who lose the least during challenging periods. Capital preservation in bear markets is necessary in order to make it to the next cycle of good times. Fortunately, our Wagner Daily ETF portfolio is all cash right now, having already realized solid profits earlier in the month. This keeps us out of trouble going into today and enables us to quickly capitalize on any golden opportunities that might materialize when the capitulation eventually comes. If you're short the market, consider trailing tight intraday stops to lock in profits into the opening gap down. Don't be greedy. Conversely, if you're still long anything going into today's session, please take a minute to review the MTG Opening Gap Rules, as they may save you a lot of money by preventing you from panic selling on the open.

Open ETF positions:

Long - (none)
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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