What happens if financial ETFs reverse?

Stocks followed through on the previous day's distribution, as the major indices registered another session of broad-based losses. Equities gapped higher on the open, but traders quickly sold into strength, sending the stock market into a downtrend that persisted throughout the entire day. The Dow Jones Industrial Average lost 0.3%, the S&P 500 0.6%, and the Nasdaq Composite 1.0%. Small and mid-cap stocks, which were recently showing relative strength to the broad market, fell the most. The Russell 2000 declined 1.5% and the S&P Midcap 400 closed 0.8% lower. The main stock market indexes settled around the bottom quarter of their intraday ranges.

Turnover was mixed. Total volume in the NYSE was 10% lighter than the previous day's level, but trading in the Nasdaq increased 6%. It was the second straight day of higher volume losses in the Nasdaq, though the NYSE managed to avert another "distribution day." An occasional round of higher volume selling is normal in uptrending markets, but the presence of more than three "distribution days" over a period of several weeks can significantly derail a rally. Despite the losses in the S&P and Dow, advancing volume in the NYSE was on par with declining volume. However, the Nasdaq adv/dec volume ratio was negative by a margin of nearly 3 to 1.

Over the past week, the S&P and Dow have shown relative strength by roughly trading in a sideways range, as the Nasdaq has been drifting lower. On closer analysis, one will see this was primarily due to strength in the financial sector over the past few days, combined with stagnation in many Nasdaq-leading stocks. This being the case, it's fair to say financials have largely been responsible for minimizing broad-based losses over the past two days. Therefore, if financials, one of the only sectors showing strength right now, were to suddenly start showing weakness, it could have negative implications for the short-term direction of the overall market. Unfortunately for the bulls, this is what may be happening; many financial ETFs formed bearish reversal candles on higher volume yesterday. We view this as a subtle, yet important, warning sign for the short-term trend. The potential reversal pattern is shown on the daily chart of Regional Bank HOLDRS (RKH) below:

Along with other financial ETFs, RKH has shown great relative strength to the broad market over the past week, as it moved higher while the major indices moved sideways to lower. But one major problem is that the entire rally occurred on much lighter than average volume. Volume finally spiked higher yesterday, but the increased trading coincided with a reversal day lower. When the highest volume of a rally occurs on a reversal bar, this is indicative of institutional selling into strength. Obviously, that is bearish. Next, take a look at a similar situation in iShares Real Estate (ICF):

With ICF, volume on the bullish day of August 5 was actually greater than average, but turnover surged even higher when ICF formed a bearish "shooting star" candlestick pattern yesterday. This is the opposite volume pattern of what should be seen in a healthy uptrend. Numerous other financial ETFs showed similar action yesterday.

The good news about the stock market's pullback of the past two days is several ETFs on our watchlist (IBB, SMH, TUR, EWP, etc.) are now approaching short-term support of their 20-day exponential moving averages (EMAs). The iShares Nasdaq Biotech (IBB), for example, is now less than fifty cents away from its 20-day EMA:

Although we're viewing pullbacks to the 20-day EMAs as opportunities to initiate new long positions in strong ETFs, this does NOT mean we immediately hit the buy button as soon as the ETF touches its 20-day EMA. When steadily trending ETFs retrace to support of their 20-day EMAs, it is rarely as simple as the first touch of the moving average leading to an immediate reversal higher. Rather, the 20-day EMA is frequently "undercut" by one to three percent, shaking out the "weak hands" who sell as soon as the support is violated, before stabilizing and attempting to move back up. As such, our plan is to continue monitoring the price action of ETFs such as IBB and SMH (Semiconductor HOLDR) as they test their 20-day EMAs, and then wait for the proper signal to enter a new position. That signal can occur in one of several ways, but one of the simplest and most effective techniques is to wait for the first rally back above the newly developed hourly downtrend line from the recent high. Frequently, such an entry won't occur until at least several days after the initial test of the 20-day EMA. While we'll continue to keep subscribers posted of any action taken with new pullback trade entries, it's important to realize continued patience is involved.

If financials follow-through on yesterday's bearish reversal candles, it could lead to substantially more downward pressure than we've seen over the past two days. This is another reason to not be in a hurry to jump back in on the long side of the stock market right now. Instead, continue closely monitoring the price action of leading stocks and ETFs, and at least waiting for the first clear sign of renewed strength, rather than picking a short-term bottom. Since our commodity and currency ETFs have low overall correlation to the direction of the broad market, we are taking a simple "set it and forget it" approach to the stop prices of our current positions while the market's near-term correction plays out.