Will this reversal be different?

It was a wild day on Wall Street yesterday, as the main stock market indexes swung in a massive intraday range of 11% before posting some of their best gains of the year. After a brief morning rally attempt failed, stocks began drifting lower at mid-day, then nosedived after most of the major indices fell below support of their October 10 lows in the early afternoon. But after the main stock market indexes plunged nearly 3% in just fifteen minutes, the bulls stepped up to the plate and changed the situation in a big way. From 1:00 pm ET until the closing bell, stocks trended steadily higher, gaining momentum along the way. Finishing at their intraday highs, the Nasdaq Composite gained 6.5%, the Dow Jones Industrial Average 6.7%, and the S&P 500 6.9%. The small-cap Russell 2000 and S&P Midcap 400 indices zoomed higher by 8.5% and 8.2% respectively.

Total volume in the NYSE motored 38% higher, while volume in the Nasdaq swelled 43% above the previous day's level. The broad-based gains on higher volume enabled both the S&P 500 and Nasdaq Composite to score a bullish "accumulation day" that was indicative of institutional buying. Although stocks declined on higher volume in the two preceding sessions, overall volume levels were more significant yesterday. Turnover in the Nasdaq, for example, rose above its 50-day average level for the first time in ten days. Unfortunately, NYSE volume remained below average. As to be expected, market internals were quite strong. Advancing volume in the NYSE beat declining volume by a margin of nearly 13 to 1. The Nasdaq adv/dec volume ratio was positive by more than 8 to 1.

In yesterday's Wagner Daily, we illustrated how the major indices were positioned to test key support of their prior lows from October. We then said, "Because this is such a major area of support, we don't expect a break of these lows to come without a bit of gyration and fakeout moves to the downside. . .There's also a good chance these prior lows will lead to another significant rally back towards the middle of the recent trading ranges." As such, it was not surprising that the mid-day breakdown to fresh five-year lows in the S&P 500 and Nasdaq Composite led to a subsequent afternoon reversal. When markets approach such obvious levels of support or resistance, "fakeout" moves that don't follow through are common. In this case, yesterday's mid-day breakdown was a "bear trap" that sucked in the short sellers. When the market subsequently began reversing higher, the bears were promptly forced to cover their positions, adding to the bullish momentum and attracting even more bulls.

When the major indices fell to new lows yesterday, we bought the inversely correlated UltraShort Oil & Gas ProShares (DUG) and UltraShort Emerging Markets (EEV), both of which broke out above resistance levels on their daily charts. Initially, both positioned rocketed higher as the stock market fell apart. However, because we were quite aware of the possibility of a "bear trap," we took a very pro-active stance to managing those positions. After the stock market recovered most of its steep losses in less than hour, we sent an Intraday Trade Alert to subscribers, informing them of our decision to scratch the trades (sell at breakeven). This was a good thing, as both DUG and EEV collapsed in the hours that followed. Even though we knew the odds of a "bear trap" sell-off were high, we took a shot with short selling because there was still the possibility of an all-out breakdown. Ultimately, there was no harm done, and no capital lost, because we micro-managed the positions at a time when it was necessary to do so.

After recent losses in the market, it may be easy to get excited about yesterday's bullish reversal and strong gains. But be aware that, including yesterday, there have been three such days of massive gains within the past month. Recall the S&P 500 rallied 11.6% on October 13, and 10.7% on October 28. What was the outcome of those days? Both times, the S&P 500 fell back to its prior lows just two weeks later. IF the same thing happens again, the major indices should follow-through with a confirmed move to new multi-year lows. Nevertheless, the scenario may play out differently this time. Yesterday's "undercut" below the October 2008 lows was bullish because it caused the remaining bulls to "throw in the towel." It's at such pivotal moments in the market, when even the die-hard bulls finally give up hope, that significant bottoms of bear markets are often formed. The daily chart of the S&P 500 below illustrates the "undercut:"

In addition to the "undercut," notice there is also a "triple bottom" formation in place, which could help stocks to build a more sustainable base of support. Still, neither the "undercut" nor "triple bottom" in the market indicates stocks have bottomed for the long-term. What is likely, however, is that we'll see a tradeable counter-trend bounce in the short to intermediate-term. Time will tell whether it becomes more sustainable than the stock market's other reversal attempts of the past month.

In the short-term, our plan is to wait for the major indices to approach support of their 20-period exponential moving averages on the hourly chart (20-EMA/60 min). During trend reversals, waiting for the major indices to touch their 20-EMA/60 min., rather than chasing a parabolic rally, is an ideal way to participate in the bullishness with a controlled level of risk. The touch of the 20-EMA/60 min. could come from a short period of sideways consolidation or a pullback in price. Either way is preferable to seeing another day of large gains without giving the market a chance to catch its breath. Next week, we'll take a look at trade setups in the industry sectors and international ETFs that may provide the best chance for outperformance if the market's rally gets some legs. For now, all bets are off on the short side unless yesterday's intraday lows are broken -- yikes!

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Open ETF positions:

Long - DGP
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.