Do you trade the SPYs? Here’s today’s possible entry

The major indices wrapped up a volatile week with a session of divergence last Friday. Strength in the Internet sector, fueled by a 12% gain in post-earnings Google, enabled the Nasdaq to lead with a 0.7% advance, but the Dow Jones Industrial Average lost 0.6%. The S&P 500 gained 0.2%, although mid and smallcap stocks showed the most relative strength. The S&P 400 and Russell 2000 indices closed higher by 0.9% and 0.8% respectively. The broad market also showed similar divergence for the week, as the Nasdaq Composite gained 0.8%, but the S&P 500 dropped 0.6% and the Dow fell 0.7%.

Total volume was 3% lower than the previous day’s levels in both the NYSE and Nasdaq last Friday. This prevented both the Nasdaq and S&P from logging another bullish “accumulation day,” as both exchanges did on Wednesday. However, volume came in above 50-day average levels and market internals were positive across the board.

The broad market began last week with a continuation of the steady downtrend that had been in place throughout the month, but stocks reversed sharply on Wednesday and higher volume confirmed the rally. Although one might have expected a sideways consolidation the following day, both the S&P and Dow gave back all of the prior day’s gains in Thursday’s session, while the Nasdaq retraced about half of Wednesday’s gain. On Friday, the Nasdaq advanced to close near Wednesday’s high, but the S&P bounced only enough to remain in the bottom third of Wednesday’s range. The Dow, conversely, finished at its worst level of the week and closed at its lowest level of the month. Put it all together and you have quite a mixed picture filled with indecision as we enter the new week.

The main index to follow this week is the Nasdaq, as it is sitting at a pivotal “make or break” level that will likely determine the broad market direction as well. The index closed the week back above its 200-day moving average, but has resistance of its 20-day MA just overhead. Even if it manages to clear its 20-day MA, the 50-day MA will be another obstacle. The daily chart below illustrates this:

One primary factor that will determine whether the Nasdaq “makes it or breaks it” will be the performance of the Semiconductor Index ($SOX) in the coming week. The $SOX formed a very bullish “hammer” candlestick and surged back above its 200-day MA on October 19, but has failed to follow-through with a lot of upside momentum since then. The 447 level is acting as resistance, so watch that level in the coming days. The dotted horizontal line on the chart below illustrates the 447 level of resistance:

Unfortunately for the bulls, the technical picture of the S&P and Dow looks much more negative. As stated earlier, both indices finished the week poorly and without seeing benefit from Wednesday’s rally. On the S&P 500, it appears the 200-day moving average will be difficult to get back above. The 20-day MA has also crossed down below the 200-day MA, creating another bearish signal.

The Dow, hovering near its October low, looks even worse than the S&P. As such, we would not be surprised to see new lows on both of these indices in the coming week. Subscribers will notice we are stalking SPY (S&P 500 Index SPDR) for a potential short entry today. However, note that the Nasdaq is showing relative strength and is therefore not in sync with the other indices. When the major indices get out of sync with each other, it often creates whippy and volatile market conditions, just as we experienced in the latter half of last week. Therefore, it is advisable to continue waiting on the sidelines until the Nasdaq determines which way it wants to go from here.

If you do continue trading in the current period, which is further complicated by earnings announcements, odds overall still seem to favor the short side of the market. Just be sure to reduce your share size and hence your total risk exposure. A vast amount of overhead supply has been created from the losses earlier this month and it won’t be easy for the indices to absorb that supply unless we begin to see a series of “accumulation days.” Water flowing down a hill always flows in the path of least resistance, and the stock market works the same way.

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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 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 .