A feeble bounce

Registering a modest advance across the board, stocks began the week with a slight bit of relief from last week's pounding, but volume levels fell off sharply. The major indices opened higher, then merely oscillated in a tight, sideways range throughout the rest of the day. The Nasdaq Composite bounced 0.5%, as both the S&P 500 and Dow Jones Industrial Average edged just 0.2% higher. The small-cap Russell 2000 and S&P Midcap 400 indices each rose 0.2% as well. Considering the main stock market indexes tumbled more than 5% over the preceding three sessions, the tiny advance was rather ineffectual. There was also a lack of conviction into the close, as the major indices closed in the bottom half of their intraday ranges.

Total volume in the NYSE receded 30%, while volume in the Nasdaq slipped 25% below the previous day's level. The sharply lower number of shares that changed hands tells us mutual funds, hedge funds, and other institutions had no interest in supporting yesterday's rally attempt. As mentioned in yesterday's commentary, we have no interest in getting long the market until we at least see a round of higher volume gains. Monitoring the stock market's price to volume relationship, and waiting for the signal of institutional buying, is a reliable, efficient way to keep investors and traders out of trouble during transitional markets.

If the pullback in the broad market fails to recover as quickly as other retracements have done, and stocks enter into a more protracted, intermediate-term correction, one of the best types of short setups may be found within ETFs that failed to breakout of bullish consolidation patterns. When that happens, the bulls who bought the consolidation quickly become trapped, forcing them to sell. In turn, short sellers become attracted to the opportunity, thereby fanning the downside wave of momentum. On the first subsequent bounce that follows, a lot of overhead supply is from the failed breakout makes it difficult for the struggling ETF to recover, which usually sends it on another leg down very quickly. One such ETF that may meet this criteria for a short setup is the iShares Real Estate Index Trust (IYR):

The dashed, horizontal line on the chart above marks what should have been support of the prior highs from last September. For weeks, while IYR was consolidating, it held firmly at that level. However, on January 21, IYR broke support of that consolidation and closed at its 50-day MA. Rather than bouncing off its 50-day MA, IYR convincingly sliced through it the following day. Now, IYR is trying to bounce, but both the 50-day MA and prior consolidation will provide formidable price resistance. As such, we're monitoring IYR for possible short entry on a bounce to the $45 to $45.50 area. But rather than actually selling short IYR, we may simply use its chart pattern to time a buy into the inversely correlated UltraShort Real Estate ProShares (SRS) instead. If we buy SRS, we'll promptly send details of the trade via Intraday Trade Alert to subscribers.

Yesterday, we said, "Although we're advocating the avoidance of new long entries into ETFs with a direct correlation to the stock market's direction, currency, commodity, and fixed-income ETFs may provide opportunities that are more immune to sharp movements in the major indices. Aside from the possibility of "short" ETFs, these three areas may be the best place to focus current buying operations." In addition to the bullish consolidation in the U.S. Natural Gas Fund (UNG), a commodity ETF, we also anticipate further near-term gains in the U.S. Dollar Bull Index (UUP). The daily chart of UUP is shown below:

We have been long UUP since January 11, when it initially pulled back to test support of its 50-day moving average. We then added to the position a week later, when it gapped up and showed signs of resuming its developing uptrend. Now, a rally above the January 21 high of $23.21 will cause UUP to break out above its December 2009 highs, and confirm the formation of a new intermediate-term uptrend. If you missed our initial pullback entry, a secondary buy entry into UUP is this breakout level. However, a slightly tighter stop would be required, in order to protect against a failed breakout.