Sell Into Strength, Wait And See Mode

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

After days of dizzying volatility, the stock market finally settled down yesterday. After gapping higher on the open, the major indices traded sideways throughout the day before closing firmly higher. The Nasdaq Composite regained leadership, climbing 1.9%. The S&P 500 and Dow Jones Industrial Average were higher by 1.0% and 0.9% respectively. Small-caps took a break from two days of relative strength, as the Russell 2000 slipped 0.1%. The S&P Midcap 400 finished 1.2% higher. With the exception of the Russell 2000, all the major indices closed near their intraday highs.

Not surprisingly, turnover eased across the board. Total volume in the NYSE declined 25%, while volume in the Nasdaq similarly registered 19% below the previous day's level. Lighter volume on consolidation days is normal, especially considering that trading had spiked to multi-month highs for several days prior. Still, volume in both exchanges remained well above average levels. Advancing volume in the NYSE exceeded declining volume by less than 2 to 1. The Nasdaq ratio was positive by nearly 3 to 1.

It's definitely too early to determine whether or not the near-term rally off the recent lows is sustainable. As such, only short-term momentum trades of 1 to 3 days should be considered if playing the long side of the market. Though the major indices could continue higher in the coming days, we sold both the ProShares Ultra S&P 500 (SSO) and Russell 2000 (UWM) into yesterday's strength. If a large gain can be realized on the long side of the market in just two days, quickly locking in the profit is better than waiting to see if stocks make another leg up. Remember that the shorter period of time in the market, the less overall risk one is taking. In a healthy bull market, however, one should conversely maximize winning positions by trailing stops as long as possible.

Within just the past two days, the S&P 500 has rallied more than 6% off its January 23 low. If it retains its pre-market gain, the index will gain another 0.9% on the open. After zooming more than 7% off its lows without a rest, one should definitely consider the potential of a significant pullback today. On a technical level, both the S&P 500 and Nasdaq Composite are approaching resistance of their 10-day moving averages. The Dow, Russell, and S&P Midcap indices already hit their 10-day MAs yesterday. Looking at the daily chart of the S&P 500, notice how a touch of the 10-day MA triggered a sell-off to new lows in mid-January:

If you're still carrying long positions that you somehow failed to unload during the recent slaughtering, it would be prudent to sell them into strength of today's open. Despite the bounce off the lows, the major indices remain in steep overall downtrends. Further, so much technical damage has been done to charts of leading stocks that they will require at least several weeks to build new bases of support.

Starting today, we will be looking for short selling opportunities in ETFs that are rallying into major areas of resistance. However, the first pullback off the recent bounce is likely to be a fakeout that sucks in shorts and subsequently leads to higher highs. That is the point where the lowest risk setups for short selling may present themselves. For now, we're once again fully positioned in cash, patiently stalking the next ideal entry point. Remember to trade what you see, not what you think!

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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