2 reasons to be cautious

The major indices oscillated around
both sides of the flat line yesterday before finishing the choppy session with
marginal gains. Both the S&P 500 and Nasdaq Composite edged 0.2%
higher, while the Dow Jones Industrial Average managed a 0.1% gain. The S&P
Midcap 400 showed a bit of relative strength by rallying 0.4%, but the small-cap
Russell 2000 only kept pace with the Nasdaq by advancing 0.2%. Each of the major
indices closed in the upper third of their intraday ranges, and at or
fractionally above their respective highs of the previous day.

Total volume in the NYSE surged 19%, while volume in the
Nasdaq was 18% above the previous day’s level. The gains on higher volume
technically gave the broad market another bullish “accumulation day.” But given
the choppy trading and minimal gains, the session was more indicative of
churning. This occurs when turnover rises significantly in both exchanges, but
the percentage gains in the S&P and Nasdaq are flat to minimal. When this occurs
after an extended rally, it is often indicative of institutional selling into
strength. Market internals were positive by a narrow margin. In the NYSE,
advancing volume exceeded declining volume by a ratio of just over 3 to 2. The
Nasdaq was positive by only 1.3 to 1.

Though the broad market has made little headway over the past
three days, it is bullish that leading stocks have been holding their recent
breakouts, while the major indices are holding at their highs in a tight,
sideways range. Overall, both price action and broad volume patterns have been
healthy and have flashed no significant warning signs to the bulls. In the
intermediate-term, odds for profitability continue to favor the long side of the
market, as there are a minimal number of quality trade setups on the short side.
However, there are two reasons we feel that prudent traders should approach the
market with an ounce of caution in the short-term.

With the Dow consolidating at its all-time high and the S&P at
more than a five-year high, there is obviously a lack of overhead supply to
weigh on those indices. However, one technical aspect that may result in at
least a temporary broad market correction is resistance of the upper trend
channels on the daily charts of all the major indices. Since forming a bottom
nearly three months ago, the broad market has been steadily trending higher.
This has resulted in the formation of clearly defined trend channels that can
help you anticipate near-term support and resistance levels. Looking at the
daily charts of the S&P and Nasdaq below, notice how both indices are sitting
near the top of their respective uptrend channels (moving averages removed so
you can more easily see the trend channels):

As technical traders, we must assume that steadily trending
stocks, indexes, and ETFs will maintain those established trends until they
prove otherwise. As such, it’s logical to anticipate a correction off the highs
of the upper trend channels. This, of course, does not mean we feel the solid
uptrends in the broad market are in danger of being broken. Rather, we are
simply suggesting the likelihood of at least a short-term correction down to
support of the bottom of the uptrend channels.

The second reason we are advising a cautious near-term stance
is the return of good ol’ quarterly earnings season. As mentioned in yesterday’s
newsletter, keystone companies have begun to report their earnings results of
the past quarter, and will continue to do so over the next several weeks. If you
have been trading for more than a few months, you are most certainly aware of
the erratic and volatile price action that often results from the release of
closely watched earnings reports from major players in a variety of industry
sectors. Earnings season is infamous for causing solid chart patterns to
completely invalidate themselves. Unfortunately, technicals often go out the
window immediately after a company reports earnings. One or two negative
earnings reports from benchmark companies could easily cause the major indices
to rapidly fall to the lower channel of the uptrends or more.

If you’re currently holding long positions that are showing a
profit, there is no reason to ditch them without cause. Even though the major
indices are already pushing the top of their trend channels, they could continue
to grind higher for days without a retracement. You might consider, however,
either reducing your share size or at least trailing your stops tighter.
Consider using intraday trend lines on the 15-minute chart interval for maximum
profitability. If you’re sitting mostly in cash now, this is where patience and
discipline is required. There will be a lot of nice buy setups if the market
corrects down to support and holds, but your risk/reward ratio of entering new
positions at current levels is negatively skewed. Be on the lookout for those
earnings land mines in the coming weeks and remember to always
trade what you see, not what you think!

Open ETF positions:

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 .