An ounce of caution is warranted here

A choppy and indecisive day of trading led to a round of moderate gains yesterday, as turnover in the Nasdaq returned to average levels. The S&P 500 advanced 0.8% and the Dow Jones Industrial Average rose 0.7%, while relative strength in the tech arena enabled the Nasdaq Composite to gain 1.5%. The small-cap Russell 2000 and S&P Midcap 400 indices climbed 1.9% and 1.6% respectively. Despite the substantial gains of the broad market, it's notable that stocks actually closed at or below their opening prices; the broad-based advance was merely the result of an upside opening gap. Like the previous day, all the major indices settled near the middle of their intraday trading ranges.

Trading in the Nasdaq swelled 23% above the previous day's level, enabling total volume in the exchange to exceed its 50-day average level for the first time in more than two weeks. Trading in the NYSE, however, edged just 1% higher. When stocks rise on higher volume (an "accumulation day"), it is usually a bullish sign that hints at institutional buying. But this time, it would be deceiving to blindly declare yesterday an "accumulation day." This is because higher volume on a choppy, range-bound session of trading that occurs after the market has registered a series of gains is typically caused by stealth institutional selling into strength. This is also known as "churning," and such action provides an early warning to observant traders that the market may enter a correction in the coming days.

CurrencyShares Japanese Yen (FXY), one of the strongest ETFs in the fourth quarter of 2008, has been in correction mode for the past several weeks. Yesterday, it dropped an additional 0.5% to close right at key support of its 50-day moving average. On the daily chart of FXY below, notice it was the first touch of the 50-day MA since the current, long-term uptrend began:

Because it is the first touch of the 50-day MA since the primary uptrend of FXY began, a buy entry near its current price is not a bad idea. However, in order to prevent getting whipsawed out of the trade with a slightly premature entry, consider at least waiting for the price of FXY to move back above resistance of its 20-period exponential moving average on the hourly chart (20-EMA/60 min.). Presently, that correlates to a rally above the $106.88 level. As FXY is a currency ETF, one bonus is that it has a low correlation to the direction of the overall stock market. Regular subscribers to The Wagner Daily should note our detailed trigger, stop, and target prices for this setup below.

In addition to yesterday's perceived "churning" in the broad market, we also were disappointed with the action of most leading stocks. Though this newsletter focuses on ETFs, not individual stocks, monitoring the price action of top-performing stocks is a great way to stay on top of the health of the overall market. When a select group of top stocks is breaking out to new highs, it drives the broad market higher. But when those stocks suddenly start failing their breakouts, it's often a leading indicator of a potential correction in the major indices. On January 5, a plethora of leading stocks surged higher while the main stock market indexes closed slightly lower. Yesterday, however, we saw the opposite action; many leading stocks sold off sharply while the broad market closed higher (only because of the opening gap up). This was not encouraging for the near-term direction of the broad market.

Upon observing the "churning" and dismal performance of leading stocks yesterday, we bought the inversely correlated UltraShort Russell 2000 ProShares (TWM), a bearish position in the broad market. While our model portfolio is still net long, TWM will serve to hedge the risk in those long positions. We've also trailed our protective stops much higher in both iShares Xinhua China 25 (FXI) and iPath India Index (INP) in order to lock in a majority of our unrealized gains if the stock market suddenly reverses. Our other open positions in the commodity-related ETFs (SLV, GDX, USO) are not as directly correlated to the direction of the stock market. Though we certainly don't have enough confirmation to declare the end of the market's seven-week rally, a substantial pullback to at least the 50-day MAs is quite realistic. Having a more balanced portfolio should serve to limit our risk and minimize volatility of our gains in the near-term.

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Open ETF positions:

Long - FXI, INP, USO, GDX, SLV, TWM
Short - (none, but TWM is a bearish, inversely correlated ETF)

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 Trade Alerts are also sent via e-mail and/or mobile phone text message on as-needed basis.

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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's new book, Trading ETFs: Gaining An Edge With Technical Analysis, was published by Bloomberg Press in August, 2008. Wagner also 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.

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.