Stealth selling into strength near the highs

Yesterday was a tale of two markets, as the bulls ran the show in the morning, but the bears took control in the afternoon. In the end, the main stock market indexes still finished modestly higher, but in the bottom quarter of their intraday ranges. The S&P 500 gained 0.6%, the Nasdaq Composite 0.5%, and the Dow Jones Industrial Average 0.4%. The small-cap Russell 2000 advanced 0.4%, as the S&P Midcap 400 closed 0.6% higher. At their mid-day peaks, all the major indices briefly probed above the highs of their consolidation patterns, but fell to close back within their recent trading ranges.

Total volume in the NYSE was on par with the previous day's level, while volume in the Nasdaq increased 5%. Although the Nasdaq technically registered an "accumulation day" by gaining on higher volume, it would be deceiving to say the session was dominated by institutional buying. On the contrary, the intraday price action was more indicative of bearish "churning," which occurs when mutual funds, hedge funds, and other big players stealthily sell into strength near the market's highs. It is typically negative when stocks sell off from substantial intraday gains to close only slightly higher, and near their lows of the day. When higher turnover accompanies such price action, it's a sign of "churning," a warning sign of institutional selling into strength that astute traders don't ignore.

In yesterday's commentary, we looked at the bullish setups in the oil sector, and suggested several ETFs in the sector were poised for breakout on any further strength in the broad market. As anticipated, the oil ETFs indeed broke out above their recent trading ranges yesterday and retained most of those gains into the close. Though we did not buy any of the oil ETFs that broke out, we entered a new position in the natural gas sector, which actually outperformed oil yesterday.

Of all the major industry sectors we monitor on a daily basis, the Natural Gas Index ($XNG) scored the largest gain yesterday (3.4%). This was followed by the Oil Service Index ($OSX), which climbed 2.7%. The strength in the natural gas sector caused U.S. Natural Gas Fund (UNG), which is tied to the price of the natural gas futures contracts, to jump more than 5%. We bought UNG when it broke out above its 20 and 50-day moving averages, as well as a short-term base of consolidation. Notably, volume spiked to nearly 400% its average daily level, hinting at institutional accumulation on the rally. UNG is now poised to break out above its month-long downtrend line within the next day or two. Our entry is shown on the chart below:

At yesterday's intraday highs, the S&P 500, Dow, and Nasdaq all traded above the highs of their recent consolidation patterns, but were unable to hold their breakouts. Subsequently finishing near their lows of the day, all three indices formed bearish "inverted hammer" candlestick patterns into the close. Below are charts of the S&P 500 SPDR (SPY), Dow Jones DIAMONDS (DIA), and Nasdaq 100 Tracking Stock (QQQQ), popular ETF proxies of each index:

Although all three ETFs have simply fallen back into their previous trading ranges, we view yesterday's intraday action as bearish for three reasons: the breakouts were unable to hold, the ETFs closed near their intraday lows, and the Nasdaq saw increasing volume. Obviously, this doesn't give us a license to start aggressively entering new short positions at current levels, but the selling into strength should serve as a warning that a substantial market correction may be coming soon. Considering the massive gains the indexes have realized since their March 2009 lows, pullbacks to the 50-day moving averages (the teal colored lines, roughly converging with the May 2009 lows) would not be surprising. Since our current positions include two ETFs with low correlation to the direction of the broad market (SLV and UNG), one long ETF with emerging relative strength (IBB), and one short ETF in a sector with developing relative weakness (SRS), we should be positioned for net profits, regardless of which way the broad market goes from here.

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Open ETF positions:

Long - SLV, UNG, IBB, SRS
Short - (none, but SRS is an 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.