The Broad Market Divergence Continues...

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

Stocks snapped their five-day winning streak yesterday, as the S&P and Dow gave back most of last week's gains. Several profit warnings from the retail sector sparked selling in the pre-market. After the initial gap down, the broad market moved sideways throughout the first half of the session, then sold off again in the afternoon. The S&P 500 plummeted 1.4%, the Nasdaq Composite 1.2%, and the Dow Jones Industrial Average 1.1%. Small-caps fared the worst, causing the Russell 2000 Index to plunge 1.8%. The S&P Midcap 400 similarly lost 1.5%, but the tech-heavy Nasdaq 100 Index showed relative strength by losing "only" 0.9%. Each of the major indices closed at their intraday lows.

Turnover rose well above the previous day's levels, as traders finally snapped out of last week's vacation mode. Unfortunately for the bulls, mutual funds, hedge funds, and other institutions returned in a selling mood. Total volume in the NYSE increased 23%, while volume in the Nasdaq came in 17% greater than Monday's level. The higher volume losses caused both the S&P and Nasdaq to register a bearish "distribution day" that was indicative of institutional selling. Ugly market internals confirmed the underlying weakness. Advancing volume in the NYSE trounced declining volume by a margin of nearly 7 to 1. The Nasdaq's ratio of just under 3 to 1 wasn't as bad.

Over the past week, we have been warning against placing too much trust in the gains of the past five days, as they all occurred on substantially lighter than average volume. When a market is rising on declining volume, it only takes one day of high volume selling to wipe out many days of gains because due to the lack of institutional demand to absorb the supply. That is precisely what happened yesterday. The S&P 500, for example, surrendered 1.4% of its five-day gain of 1.8%.

In yesterday's commentary, we said that, ". . . one of two major scenarios is likely to occur this week. Either the Nasdaq stands firm and pulls the S&P and Dow back to new highs OR the laggard S&P and Dow indexes fall back down below their 50-day MAs, pulling the Nasdaq lower as well." Resistance of the prior highs in the S&P and Dow gave traders the perfect excuse to dump shares of stock yesterday, causing the former index to lose support of its 50-day moving average. Notice how the S&P reversed right at resistance of its intermediate-term downtrend line, then closed below both its 20 and 50-day MAs:

As long as the S&P holds above its June lows, we can't be overly bearish on the intermediate to long-term view of the market. Nevertheless, many sectors in the S&P and Dow are forming bearish patterns and should be avoided. Conversely, the positive of yesterday's session is that many market-leading Nasdaq stocks not only held firm, but a few continued to rack up gains. Chinese Internet search provider Baidu.com (BIDU) zoomed 10 points yesterday, while Apple Computer rallied 2 points. Until leading stocks such as these begin to roll over, the Nasdaq is not likely to drop very far. On a relative basis, the Nasdaq 100 Index (QQQQ) retraced only a small portion of its recent gains. More importantly, notice how QQQQ remains firmly above the pivotal support of its breakout level (the blue dashed horizontal line):

If QQQQ pulls back further in today's session, down to the $48 area, it will present a low-risk buying opportunity. Prior resistance of the multi-year high should now act as major support. The 20-day EMA will also provide support just below that level. But all bets are off on buying a QQQQ pullback if the market leaders begin sliding substantially lower today. With corporate earnings season underway, be sure to also stay on top of leading companies reporting dates, as more negative surprises could have a very adverse effect on stocks.

Open ETF positions:

Long - FXC, GDX

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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