Stuck in the middle with you

Stocks concluded a bearish week on a positive note last Friday, as the major indices gapped higher on the open, then bobbed and weaved in a sideways range throughout the trading session. Both the S&P 500 and Dow Jones Industrial Average climbed 2.9%, while the Nasdaq Composite rallied 2.4%. The small-cap Russell 2000 and S&P Midcap 400 indices advanced 2.0% and 2.5% respectively. With a little more than an hour remaining during last Friday's session, the stock market initially sold off as President Elect Barack Obama held his first news conference since the election, but the bearish knee-jerk reaction quickly faded. In the last thirty minutes of trading, the main stock market indexes reversed to finish near their best levels of the day. For the week, the S&P 500 fell 3.9%, the Dow Jones Industrial Average declined 4.1%, and the Nasdaq Composite lost 4.3%.

It was positive that stocks finished the week with a solid session of gains, but negative that lighter turnover accompanied the rally. Total volume in the NYSE receded 18%, and Nasdaq volume declined 24% below the previous day's level. Heavier turnover would have indicated the return of institutional accumulation after two days of sharp losses, but mutual funds, hedge funds, and other big players apparently remained on the sidelines. This was indicated by the fact that NYSE volume dropped to its lowest level since August 29 of this year -- the week before Labor Day is typically one of the slowest of the year. In both exchanges, volume was also well below 50-day average levels. Market internals, however, were solid. Advancing volume in the NYSE exceeded declining volume by 4 to 1. The Nasdaq adv/dec volume ratio was positive by 3 to 1.

From October 28 through November 4, the major indices helped ease the pain of October's massive losses by bouncing approximately 18.5% off their lows. However, the broad market swiftly tumbled about 10% from November 5 to 6. In the November 7 issue of The Wagner Daily, we illustrated how the S&P 500 had sold off to close at key support of its 61.8% Fibonacci retracement. Specifically, we said, "Generally, the 61.8% Fibonacci retracement level is considered to be the "last line of defense" when a stock or index is experiencing a pullback. If the retracement goes beyond the 61.8% retracement level, it significantly increases the odds of a complete reversal back to the prior low. . .it's crucial that the S&P 500 recaptures some of its losses of the past two days by the closing bell. If it does, a resumption of the fledgling rally off last week's lows could develop next week. But if the S&P fails to regain any ground today (November 7), a test of last month's lows will likely confront traders instead."

Fortunately for the bulls, the S&P 500 took its cue by closing the week to bounce off support of its 61.8% Fibonacci retracement. But taking an updated look at the daily charts and volume patterns of the major indices, we're becoming less convinced the market's recent bottom will prove to be significant. Instead, it's starting to look as though the broad market may settle into a wide, sideways trading range. Below is a daily chart of the S&P 500:

On the chart above, the yellow-shaded rectangle annotates the sideways range of the broad market over the past month (on a closing basis). Notice how the S&P 500 is presently near the middle of that range, after bouncing off its 61.8% Fibonacci retracement from the October 28 low to November 4 high. If bullish momentum continues this week, the S&P 500 could recover back above its 20-day exponential moving average (the beige line), but watch for the upper channel resistance of the sideways range, just over the 1,000 level. Furthermore, the 50-day moving average (the teal line) has been descending to close in on the price of the S&P 500. Expect the 50-day MAs to exert substantial downward pressure as they start to "catch up" to the prices of the major indices. The longer the S&P 500 remains in the consolidation pattern shown above, the more likely it will eventually lead to new lows in the coming weeks or months. Just as consolidation at the highs of an uptrend is bullish and usually leads to new highs, price consolidations near the lows of a downtrend usually lead to new lows. This is especially true when upside volume has been minimal. Nevertheless, a rally above both the upper channel resistance (1,006) and the 50-day MA (presently 1,077) would reduce the bearish probability of new lows in the intermediate-term. Since the broad market is now stuck in a sideways trading range until it proves otherwise, below is a summary of a few things you can do to increase your odds of profitability in such conditions.

Adapting to sideways trading ranges in the market:


• For new long positions, focus on buying pullbacks to support levels, such as the 10 or 20-day moving averages, rather than buying breakouts above price resistance. When the overall market is in a sideways range, breakouts to new highs have a higher rate of failure.
• Consider selling long positions into strength, whenever the S&P 500 approaches the upper channel resistance of its recently established trading range. This is doubly important as the 50-day MA closes in on the price of the S&P 500.
• Position yourself on both sides of the market to minimize risk while the sideways consolidation remains in effect. Buy ETFs and stocks with relative strength to the broad market, while simultaneously selling short those with relative weakness (or buying an inversely correlated ETF).
• Reduce position size on all new trades, in order to minimize risk throughout the high volatility and indecisive market action.

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Open ETF positions:

Long - DGP, IBB, FXY, LQD
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.