Waiting for the "real" reaction

A bearish reaction to the latest, highly anticipated economic stimulus/bank rescue plan sparked a sharp sell-off that caused the major indices to plunge more than 4% yesterday. Though the stimulus plan was largely as expected, a lack of details surrounding a few key points did not sit well with traders. The Nasdaq Composite lost 4.2%, the Dow Jones Industrial Average 4.6%, and the S&P 500 4.9%. The small-cap Russell 2000 and S&P Midcap 400 indices tumbled 4.7% and 4.75% respectively. All the main stock market indexes closed near their worst levels of the day.

Total volume in the NYSE raced 40% above the previous day's level, while volume in the Nasdaq ticked 31% higher. Trading was also well above average levels, as NYSE volume surged to its highest level this year. The stock market's damaging losses on substantially higher turnover caused both the S&P 500 and Nasdaq Composite to suffer a bearish "distribution day." Ugly market internals also accompanied yesterday's nosedive. In the NYSE, declining volume destroyed advancing volume by a margin of more than 30 to 1. The Nasdaq adv/dec volume ratio was negative by approximately 14 to 1. This tells us the selling was extremely broad-based, not just focused on the financial sector. Despite last week's encouraging sessions of higher volume gains, yesterday's fast-paced selling and overly bearish internals calls the current rally into doubt.

Yesterday's stumble caused the Nasdaq Composite to dip back below its 50-day moving average, while causing the blue-chip Dow Jones Industrial Average to revert back to the area of its January lows. The good news, however, is that the S&P 500 and Nasdaq Composite are still holding support of their multi-month uptrend lines, and the Dow is still (barely) holding its recent lows. Below is an annotated snapshot of each of index:

When the market makes a big one-day move, it's easy for emotions to take over, causing one to lose perspective of the prevailing technical patterns. Yesterday's action indeed put a dagger in the short-term bullishness that was developing; yet, the charts above illustrate that the intermediate-term patterns have not changed. Until the support levels shown above are broken, the broad market remains in a choppy, sideways range.

On common "Fed days," when the Federal Reserve Board announces changes to economic policy and interest rates at 2:15 pm ET, a strong stock market reaction, in either direction, usually follows in the final ninety minutes of trading. However, this initial "knee-jerk" reaction is often contrary to the real reaction that follows one to three days later. Because of this, we typically avoid basing major trading decisions on the stock market's immediate reaction to Fed days, preferring instead to see the true trend that subsequently develops a few days later.

Though it wasn't a typical "Fed day," the anticipation leading up to yesterday's announcement means could easily find the initial "knee-jerk" reaction to the stimulus plan to be a false indicator as to the market's real reaction that will follow in the days to come. There's also the strong possibility additional news and details surrounding the plan will come to light. Obviously, there is no guarantee stocks will rally in the near-term, but prudent traders should consider taking a "wait and see" approach, rather than immediately closing all long positions and jumping back on the short side of the market. Considering the S&P and Nasdaq are still holding support of their intermediate-term uptrend lines, and the Dow is still clinging to its January lows, the intermediate-term trends of the broad market technically remain "up." If those trendlines are violated, we will start looking at the short side of the market again. Patience pays.

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Open ETF positions:

Long - DGP, GDX, IBB, UGA, INP
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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.