Sentiment Has Drastically Changed

Stocks gapped slightly higher in an attempt to follow-through on last Friday's modest rebound, but traders immediately sold into strength, sending the broad market sharply lower in the morning session. The major indices stabilized in the afternoon, but recovered only a small percentage of the morning losses. The Nasdaq Composite slid 0.8%, the Dow Jones Industrial Average 0.7%, and the S&P 500 0.5%. The small-cap Russell 2000 fell 0.9% and the S&P Midcap 400 lost 0.5%.

The one positive about yesterday's session is that the broad-based losses occurred on lighter volume. Total volume in the NYSE declined by 10%, while volume in the Nasdaq was 4% lower than the previous day's level. Yesterday's lighter volume enabled the Nasdaq to dodge what would have been its fourth "distribution day" within the past four weeks, but market internals were nevertheless bearish. In the Nasdaq, advancing volume exceeded declining volume by a ratio of 4 to 1. The NYSE ratio was negative by 2.2 to 1. Keep a close eye on the running count of bearish "distribution days" because four or more days of higher volume selling within a one-month period typically causes even the strongest markets to suffer a substantial correction. In addition to two consecutive days of institutional selling last week, the Nasdaq also registered a "distribution day" on December 29. The S&P 500 has had two "distribution days" within the past four weeks.

While many ETFs have begun to exhibit substantial signs of weakness, one ETF that has been largely ignoring the broad market is the Biotech HOLDR (BBH | Quote | Chart | News | PowerRating). Since breaking out to a new 52-week high on January 11, BBH has been trending steadily higher in an orderly fashion. We were waiting for a few days of sideways price action in order to take a position on the pullback, but it never came. However, BBH formed a bearish candlestick yesterday, indicating that it may finally be poised for a short-term correction. It gapped open above the previous day's high, then rallied on the open, but sold off in the afternoon and closed at its intraday low. The end result was the formation of an "inverted hammer" candlestick, a pattern which often precedes a short-term top. Our plan is to buy BBH on a pullback to support of its breakout level, not to call a top and sell it short. As you can see on the daily chart below, the $193.25 area marks support of the breakout level (which was prior resistance). A retracement down to this level within the next few days will constitute a low-risk entry point on the long side of BBH. As long as the Nasdaq doesn't completely fall apart from here, we plan to buy BBH on such a pullback:

Another ETF we are watching on the long side is the StreetTRACKS Gold Trust (GLD | Quote | Chart | News | PowerRating), which roughly trades at 1/10 the price of the spot gold commodity. GLD got off to a rough start this month, losing nearly 5% in the first three trading days of the year, but it has been grinding its way back since then. Now, it is again within striking range of breaking out above its eight-month downtrend line. A rally above yesterday's high would represent such a breakout. This is illustrated on the long-term weekly chart below:

In yesterday's newsletter, we mentioned that we were remaining alert for a potential break of the 50-day moving averages in both the Nasdaq Composite and Nasdaq 100 indices. Within the first hour of trading, both indices had already done so, triggering our long entry in the UltraShort QQQ ProShares (QID | Quote | Chart | News | PowerRating). More importantly than an intraday probe below their 50-MAs, both indices also closed below that pivotal support level. The last time the Nasdaq Composite finished below its 50-day MA was on December 22, but it snapped back above it the next day. Since it closed below its 50-MA by only a small margin yesterday, it could do the same thing again today. However, as we mentioned yesterday, the overhead supply created from last week's failed breakout may make it more difficult for the Nasdaq to recover this time. A close below yesterday's intraday low of 2,422 (1,771 for the Nasdaq 100) should confirm a break of the 50-day MA.

Within a very short period of time, the sentiment and dynamic of the stock market has drastically changed. Two weeks ago, the Nasdaq firmly broke out to a new six-year high, fueled by strength in leading stocks like Apple (AAPL | Quote | Chart | News | PowerRating) and Google (GOOG | Quote | Chart | News | PowerRating), as well as a breakout in the Semiconductor Index ($SOX). But now the Nasdaq has failed its breakout and is already back below its 50-day MA. Worse is that the $SOX has broken its 200-day MA. Former leaders like Apple, which has shed 10% in the past four sessions, have started to come unglued. Why the sudden change of heart? Thank our good friend, quarterly earnings season. We warned of putting too much faith in technical chart patterns during earnings season, and the current environment is a perfect example of why we have been so cautious on the long side. A plethora of additional earnings reports are on tap over the next week, so stay on your toes!

Open ETF positions:

Long QID, short EEM, FXI (regular subscribers to The Wagner Daily receive detailed stop and target prices on open positions and detailed setup information on new ETF trade entry prices. Intraday e-mail alerts are also sent as needed.)


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 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 or to learn about Deron's other services, visit morpheustrading.com or send an e-mail to deron@morpheustrading.com .