Bullish bias remains but here’s why I’m cautious

December 6, 2005
Deron Wagner

The broad market sold off moderately yesterday, as turnover increased in the NYSE. A 1.6% drop in the Semiconductor Index
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PowerRating) weighed on the Nasdaq Composite, which fell 0.7%. The S&P 500 and the Dow Jones Industrials lost 0.2% and 0.4% respectively. The small-cap Russell 2000 Index shed 0.6%, while the mid-cap S&P 400 Index gave up 0.4%. Most of the session’s losses occurred within the first hour of trading, as stocks traded in a choppy, sideways fashion throughout the rest of the day. Each of the major indices also closed near the middle of their intraday ranges, confirming yesterday’s indecision amongst traders.

Unfortunately for the bulls, total volume in the NYSE was 11% higher than the previous day’s level. The higher volume losses added another bearish “distribution day” to the S&P’s tally. It was the third such day of institutional selling within the past six sessions. One or two days of higher volume selling in short succession is normal within the context of a strong uptrend, but our red caution flags are always raised if we see more than three “distribution days” within a two-week period. This is even more significant if the “up” days begin occurring on lower volume as well. The one positive, however, is that total volume in the Nasdaq actually declined by 5% yesterday, preventing that exchange from also registering a “distribution day.” Remember that paying close attention to the broad market’s price to volume relationship on a daily basis is one of the best ways to measure the true health of the stock market. It also enables you to predict a change in bias before price action actually shows it.

While scanning for potential sector trend reversals, we came
across one sector that we have not discussed recently, but may be in the process
of reversing. The Pharmaceutical Index
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PowerRating) has been in a steady downtrend
on its daily chart since September of this year, while its longer-term weekly
chart shows a downtrend that has been intact for several years. Sectors that
have been strong for several years will eventually fall out of favor due to
institutional sector rotation, but the same is true of sectors that have been
weak for many years. But the key is to definitely wait for some technical trend
reversal before blindly trying to catch a bottom. Most notably, we noticed that
the DRG Index appears to be forming its first “higher low” within the context of its daily downtrend. We have circled this on the daily chart below:

Considering the huge amount of overhead supply and technical resistance, it is way too early to say the Pharmaceutical sector is now going to reverse its downtrend. However, it does appear to be putting in at least a short-term bottom and, as such, merits being added to your long
watch list. Confirmation of an intermediate-term trend reversal would be
confirmed if the DRG rallies above its November high of 315. Such a move would also put the index back above both its 20 and 50-day moving averages.
(
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PowerRating) (Pharmaceutical HOLDR) is similarly attempting to form a double bottom
here and has a similar chart pattern to the DRG Index.

Although the S&P 500 Index and Nasdaq Composite both closed last month at new four-year highs, the Dow Jones Industrials remains below its prior 52-week high that was set in March of this year. The index tested that 11,000 resistance level last week, but has so far been unable to rally above it:

One could argue that the relative performance of the Dow is not very important because the index is only comprised of a narrow mix of thirty stocks. Such a position would not be unreasonable. However, as is often the case in the stock market, the importance of the Dow lies in the general public’s perception of its performance. The longer the Dow is unable to rally back above the 11,000 level, the more retail investors will begin to perceive the market is not in a good long-term position. Whether or not that line of reasoning is correct is irrelevant. The perception alone can eventually lead to fear, which leads to selling. This is the reason why we still follow the performance of the long-standing Dow Jones Index on a daily basis. How much higher can the S&P and Nasdaq rally if the Dow remains unable to set a new 52-week high as well?

As discussed yesterday, our intermediate-term bias remains bullish overall, but the S&P’s recent “distribution days,” combined with the lag in the Dow Jones, has given us legitimate reason for caution on the long side. Any new long positions in the short-term will be entered with reduced share size to compensate for the additional risk. As for the short-side, we have a few ETFs in mind, but we need to see a little more negative price and volume confirmation first. In the interim, we feel cash is king. Keeping cash on the sidelines will enable you to quickly and easily take advantage of the market’s next clear opportunity whenever it presents itself.

Open ETF positions:

We are presently flat. (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 .

Bullish bias remains but here’s why I’m cautious

BUY THE FEAR, SELL THE GREED

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