Exercise Caution in this Choppy Market

Just when we thought it was safe to
go back in the water, the fins re-appeared.
Despite the prior day’s fresh six-year high in the S&P 500, as well as new
record highs in the Dow and S&P Midcap, the stock market was lambasted
yesterday! With the exception of the Dow Jones Industrial Average, which fell
“only” 0.9%, every one of the major indices shed more than 1%. The S&P 500 lost
1.1%, both the small-cap Russell 2000 and S&P Midcap 400 indices surrendered
1.2%, and the Nasdaq Composite gave up 1.3%. The tech-centered Nasdaq 100 Index
plummeted 1.4%. Just as stocks trended steadily higher intraday and closed at
their best levels in the previous session, they trended steadily lower and
closed near their intraday lows yesterday.

Total volume in the NYSE increased by 10% yesterday, causing
the S&P to register its third “distribution day” within the past four weeks.
Turnover in the Nasdaq was 1% lighter than the previous day, but still came in
above its 50-day average level. In both exchanges, declining volume exceeded
advancing volume by a margin of 2.7 to 1.

After registering its largest daily gain of 2007 on Wednesday,
the S&P 500 followed up with its largest daily loss of the new year yesterday.
Such is the erratic state of the stock market lately. Since the start of the new
year, forecasting the market’s next move, even through sound technical analysis,
has admittedly been a very challenging task. It’s been several years since I
personally have seen market sentiment change so frequently, in such a short
period of time. Clear setups have been presenting themselves, both on the long
and short side of the market, but many entries have resulted in stopping out
before the trade follows through in the anticipated direction. Case in point is
our recent short entries in two international ETFs, the iShares Xinhua China
25
(
FXI |
Quote |
Chart |
News |
PowerRating) and the iShares Emerging Markets Index
(
EEM |
Quote |
Chart |
News |
PowerRating).

One week into the month of January, both ETFs had sold off
sharply from parabolic moves and had broken below support of their primary
uptrend lines. We subsequently waited for the proper bounce into resistance,
then initiated short entries, expecting they would at least retest their
lows and possibly form new lows. Given the severity of the selloff, we did not
expect a bounce to more than 50% of the downward move. However, EEM rallied all
the way back to its prior high, while FXI retraced more than 2/3 of its downward
move. This caused us to stop out of both positions, but both ETFs collapsed
yesterday, only one day after covering the FXI short position and two days after
covering EEM. FXI fell 5% and EEM dropped 3%:

It is frustrating when stocks and ETFs go in the expected
direction immediately after stopping out, but such action is merely a product of
the environment. The only thing to do is either re-enter the position upon
confirmation of the anticipated trend direction or remain on the
sidelines.

Given the whipsaw market we are experiencing, what is a
disciplined, professional trader or investor supposed to do? We recommend the
same things discussed in yesterday’s newsletter — a minimal quantity of
positions and smaller share size on all trades. Even the most astute
traders are likely to sustain losses in this type of environment, so don’t feel
bad if you’ve been having a difficult time lately. However, the one thing that
separates true professionals from novices is that professionals always have
parameters in place to limit their losses when the going gets rough. If you’re
sitting on losing positions, don’t be stubborn and fall into “hope” mode.
Negligible losses can easily be recovered in a short period of time, but
substantial losses cannot be. Trading conditions will eventually improve, making
it easier to profit once again, but that won’t do you any good if your trading
capital has dwindled away. Capital preservation is your top priority right now!

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 .