A rapid change of market sentiment

Gapping down to open near last week's lows, the stock market quickly trapped the bulls who bought last week's broad market pullback to key support levels. As such, the situation rapidly deteriorated, as bulls were forced to sell their positions and the bears joined in the selling. Stocks trended steadily lower throughout the entire session, before eventually closing at their dead lows of the day. The Dow Jones Industrial Average tumbled 2.4%, the S&P 500 3.1%, and the Nasdaq Composite 3.4%. The small-cap Russell 2000 plunged 3.9%, as the S&P Midcap 400 fell 3.7%. With the exception of the Nasdaq brothers, all the main stock market indexes closed below their 50-day moving averages, for the first time in nearly three months.

Total volume in the NYSE declined 17%, while volume in the Nasdaq receded 32% below the previous day's level. Even though volume was technically lighter in both exchanges, remember the previous day's volume levels were artificially inflated by "quadruple witching" options expiration day. The effect of options expiration on volume levels is also the reason we cautioned against labeling last Friday's session as a bullish "accumulation day." Ugly market internals also prevented traders from taking solace in the deceivingly lower volume levels. In the NYSE, declining volume creamed advancing volume by a margin of 14 to 1. The Nasdaq adv/dec volume ratio was similarly negative by 10 to 1.

In yesterday's commentary, we said, "The S&P 500 closed right at resistance of its 20-day EMA, while support of the 200-day MA is below. So far, the S&P has retraced about one-third of its loss from the June 11 high, down to the June 17 low. Unless the index retraces more than two-thirds (or a 61.8% Fibonacci retracement) of its recent pullback, we must be very cautious with new long entries, especially considering the S&P and Nasdaq just suffered three bearish "distribution days." Rather than recovering even half of its recent losses before heading lower, the S&P 500 plunged below last week's lows after making less than a 38.2% Fibonacci retracement. Below, this is shown on the short-term hourly chart of the S&P 500 SPDR (SPY), a popular ETF proxy for the S&P 500 Index:

It's quite a sign of weakness that the S&P only managed to recover about one-third of its recent losses before breaking down to a "lower low." Given the resilience of the market over the past several months, one might have expected at least a 50% retracement before seeing additional selling pressure, but overall market sentiment appears to be changing very rapidly. Supporting the change to a more bearish sentiment was the S&P 500's breakdown below key support of both its 50 and 200-day moving averages. At a minimum, we now expect a test of the May 2009 lows, less than 2% below the current price of the index. With its three-month uptrend line already broken and a short-term downtrend firmly underway, the S&P 500 will be looking at a bearish intermediate-term trend reversal if the index forms a "lower low" by closing below its May low. On the daily chart of SPY below, the dashed, horizontal line marks that key area of price support to monitor in the coming days:

In addition to the S&P 500, the Dow Jones Industrial Average, Russell 2000, and S&P Midcap 400 indices all closed below their 50-day MAs as well. The relatively strong Nasdaq Composite and Nasdaq 100 indices remain above their 50-day MAs, but just one more day of substantial selling would change that situation.

As the short-term downtrend picks up momentum, and the main stock market indexes break down below their 50 and 200-day moving averages, several of the inversely correlated Short and UltraShort ETFs have started to look attractive. UltraShort Real Estate ProShares (SRS), which we bought on June 10 and 11, broke out and held above its 20-day EMA last week. Then, in yesterday's broad-based weakness, it gapped up above last week's highs and finished the day with a whopping 10% gain. On June 17, we sold half of our SRS position into strength, locking in a gain of 11%, but kept the remaining half position in anticipation of rally up to its 50-day MA. Now, with an 18% unrealized gain, the remaining half position of SRS is nearing our original price target, which was resistance of its 50-day MA. We expect to take profits on the rest of the trade within the next day or two, but will keep SRS on our watchlist for potential re-entry on a pullback or breakout of consolidation. The DJ Real Estate Index ($DJR) is one of the weakest sectors on our industry watchlist right now.

When the stock market gapped down below support of last week's lows yesterday morning, and showed no signs of reversing, we sent an Intraday Trade Alert to subscribers, notifying them of a new, short-term buy into UltraShort S&P Midcap ProShares (MZZ). Unless it closed with a significant profit buffer, in which case we would take the trade overnight, we planned to manage the position as a daytrade. Since the S&P Midcap 500 closed at its dead low of the day, firmly below support of last week's low, we kept MZZ overnight. Our plan is to take advantage of a sell-off down to the May lows in the major indices (which is obviously the May highs in MZZ). Because of the intensity of yesterday's breakout in MZZ, we now can trail our stop to near the break-even level, thereby removing most risk from the trade. The dashed, horizontal line on the daily chart below marks our approximate profit target in the MZZ trade:

Over the past few weeks, we've been monitoring the tight, sideways range on the Financial SPDR (XLF). Yesterday, that ETF convincingly broke down below support of its 50-day moving average, after falling below its 20-day EMA on June 17. Though we don't expect a test of the March 2009 lows in XLF, a 50% retracement of the entire upward move would not be surprising. That would put XLF around the $9.50 area, about 16% below it current price:

Those looking to take advantage of a short to intermediate-term correction in the financial sector, could obviously consider selling short XLF. But if you're trading an IRA, or other "non-marginable" account where short selling is not permitted, you might alternatively consider buying the inversely correlated UltraShort Financial ProShares (SKF), which has just reversed to a short-term uptrend. If you're new to trading the inversely correlated and leveraged ETFs, it's important to realize these instruments are designed primarily for short-term trading and hedging purposes, not long-term investments (see the February 6, 2009 issue of The Wagner Daily for an explanation of this).