Our ounce of caution was indeed warranted

As anticipated, stocks followed up Tuesday's "churning" with a sharp pullback across the board yesterday. After opening substantially lower, the major indices valiantly attempted to rebound later in the morning, but fell to new intraday lows later in the day. The Dow Jones Industrial Average shed 2.7%, the S&P 500 3.0%, and the Nasdaq Composite 3.2%. The small-cap Russell 2000 tumbled 3.4%, enabling us to lock in a quick, overnight gain of 4.6 points (7.6%) on UltraShort Russell 2000 ProShares (TWM), which we bought to hedge our long positions on January 6. The S&P Midcap 400 lost 3.3%. A modest bounce in the final minutes of trading enabled the main stock market indexes to finish above their worst levels of the day.

Total volume in the NYSE eased 8%, while volume in the Nasdaq decreased 6% below the previous day's level. The lighter turnover in both exchanges enabled the S&P 500 and Nasdaq Composite to avert the label of a "distribution day." However, remember that the prior day's "churning" was already indicative of institutional selling into strength. Volume commonly decreases on losing days that follow concealed selling into strength near the highs.

In yesterday's market analysis, we pointed out the buy setup in CurrencyShares Japanese Yen (FXY). After correcting down to support of its 50-day moving average for the first time in five months, we planned to buy FXY on a rally above the January 6 high. That buy entry point occurred right on the market's open, and FXY subsequently moved higher throughout the day. Our entry, target, and stop prices for this trade are annotated on the daily chart below:

After discussing the "churning" and dismal performance of leading stocks on January 6, we concluded yesterday's commentary by saying, "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." Since yesterday's 3% drop in the S&P 500 caused the index to close within 2% (18 points) of its 50-day MA, it appears our projected correction is under way. On the daily chart of the S&P 500, we've highlighted this important area of key price support for the current pullback:

Obviously, there's no guarantee yesterday's selling was just an orderly pullback that will soon be followed by another wave of buying, and a rally back up to the recent highs. After all, every other rally over the past six months has only led to new lows. Still, it doesn't appear the broad market is ready to re-test its 52-week lows just yet. The simple fact that the S&P 500 is currently pulling back to support of its 50-day MA, rather than rallying into resistance of its 50-day MA makes a big difference in overall market sentiment. This is because mutual funds, hedge funds, and other market-moving institutions frequently use the 50-day moving averages as a gauge of overall market trend, and hence the aggressiveness of their buying operations.

It's quite possible the stock market will eventually fall to new lows sometime in 2009; however, considering the extent of last year's losses, the current intermediate-term rally could easily continue much higher before the bears resume control again. Remember to follow the price of the iShares 20+ year T-Bond (TLT) as an inversely correlated leading indicator of money flow into the overall equities markets. Monitoring the performance of leading individual stocks also tells us a lot about the health of the market's intermediate-term rally that's still alive and well.

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Open ETF positions:

Long - FXY, FXI, INP, USO, SLV, 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 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.