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A test of the key price support levels illustrated in yesterday's Wagner Daily triggered a moderate bounce in the major indices. After hovering near the flat line for the first half of the day, the broad market trended higher in the afternoon. The S&P 500 advanced 1.0%, the Nasdaq Composite 0.8%, and the Dow Jones Industrial Average 0.7%. The small-cap Russell 2000 and S&P Midcap 400 indices were higher by 0.8% and 0.9% respectively. All the major stock market indexes finished within the upper quarter of their intraday ranges.

As is common in weak markets, turnover declined as stocks rose yesterday. Total volume in the NYSE fell 13%, while volume in the Nasdaq came in 11% lighter than the previous day's level. Higher volume would have pointed to institutional players jumping back in the stock market, but there apparently has not yet been an impetus to do so. Considering how negative the levels were on the way down, market internals were modest during yesterday's bounce. Advancing volume in the NYSE exceeded declining volume by 3 to 1. The Nasdaq ratio was positive by just over 5 to 2.

The question on the minds of many investors is whether or not yesterday's bounce had any real significance. Has the broad market started to form a bottom already, or was it merely a bounce from "oversold" conditions that will just lead to new lows in the near future? All we can do to attempt to answer that question is look at the available facts.

The main bullish argument is that recent market corrections have righted themselves quite rapidly. In late February and early March of this year, the S&P 500 fell more than five percent over a two-week period. Historically, corrections of such intensity usually require several months before the major indices begin moving back to their highs. But stocks snapped back with a vengeance, sending most of the major indices to new highs just one month later. One could logically argue the S&P 500's current six percent correction off its record high will follow the same path that it did in March.

Bears, on the other hand, are armed with several reasons why things may be different this time around. Aside from the all the talk of subprime lending troubles, a credit crunch, and all the other fallout that resulted, there are some less obvious technical concerns that the popular financial media has been failing to discuss.

Among the biggest areas of technical trouble is the humongous drop in the small-cap arena. In just two weeks, the Russell 2000 has plummeted 9% from its all-time high. Worse is that it blew through pivotal support of its 200-day moving average without even attempting to bounce off of it for more than a few hours. When the stock market corrected in late February and early March, the Russell similarly dropped 8% before reversing, but it also held well above its 200-day MA. Whenever an index breaks below such a major level of support as the 200-day MA, it creates a lot of overhead supply that is rarely easily absorbed. The last time the Russell corrected from an uptrend and dropped below its 200-day MA was June of 2006. Upon doing so, it took more than four months before the index successfully reversed and held above its 200-day MA. Another bounce in the market will only cause the Russell to run into new resistance of its 200-day MA, in turn triggering more selling. The Russell's recent break of its 200-day MA is shown below on the chart of the popular iShares Russell 2000 ETF (IWM):

In addition to the Russell, several other key sectors have already fallen firmly below their 200-day MAs. They are: Utilities ($DJU), Retail ($RLX), REITs ($DJR), Banking ($BKX), Insurance ($IUX), and Securities Broker-Dealers ($XBD). Of these, only the $XBD index dipped below its 200-day MA during the February - March correction. Like the Russell 2000, mid-2006 was the last time most of these sectors were trading below their 200-day MAs. An average of four months was required for them to just move back above their 200-day MAs. It was much longer until they climbed back to their prior highs.

Aside from the numerous breakdowns below the 200-day MAs, the tremendous overall volume spike that occurred in the markets on July 26 can not be ignored. Remember we pointed out that volume in the NYSE that day surged to its second highest level ever! It simply cannot be denied that stocks were under intense institutional distribution at the time. As such, why would the "smart money" aggressively jump back in the markets so soon? Presently, the market lacks any significant stimulus, whether technical, economic, or geopolitical, for large funds to resume their prior levels of buying.

While we can use available technical data to create logical scenarios that stocks might follow, don't forget that the stock market doesn't care what we think! Just as water running down a hill will always flow around rocks and other obstacles, the stock market also follows the path of least resistance. As such, it always does what it wants to do. All we can do is be prepared for any possible outcome.

With all the major indices now in intermediate-term downtrends, our plan is pretty simple. Now that a bounce has begun, we will look to initiate new short positions upon confirmation that the bears have resumed control. This might take place when the major indices begin breaking back down below support of their hourly uptrend lines that have begun to form. The sectors we mentioned that have already broken below their 200-day MAs have the most relative weakness and therefore comprise our short watchlist. On the long side, the Oil Service Index ($OSX) is about the only sector that is still near its high. A few sectors such as the Semiconductor Index ($SOX) are now bouncing off support of their 50-day MAs, creating possible short-term momentum trades on the buy side. If buying anything right now, be sure to keep tight stops and reduce position size to decrease your risk exposure. Selling into strength to lock in gains, rather than trailing stops, is also a good idea.

We're still flat, waiting patiently for proper trade entries to present themselves. However, subscribers should be pleased that we locked in gains on the long side just before the big sell-off began. Realize that we also have a track record of consistent profitability during past bear markets, should we enter into a more sustained period of decline.

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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