Expect a lot of volatility this week

The broad market grinded higher
throughout last Friday’s session, capping a strong week for the major indices.
Both the Nasdaq Composite and small-cap Russell 2000 indices again showed
leadership by gaining 0.5% and 0.7% respectively. The S&P Midcap 400 matched the
performance of the Nasdaq by rallying 0.5%, but the Dow Jones Industrial Average
took a breather and eked out only a 0.1% gain. The S&P 500 advanced 0.2%. Tech
and small-cap growth stocks, laggards since the S&P and Dow rally began in July,
began showing relative strength last week and are quickly "catching up" to the
other indices. This is apparent by comparing the weekly performance of the major
indices. The Russell 2000 zoomed 3.1% higher and the Nasdaq cruised 2.5% higher
last week, but the S&P 500 "only" gained 1.2%. The Dow’s 0.9% gain was more
subdued, but the index has been leading all the other indices since bullish
reversal began three months ago. The Dow also finished at its highest level of
the week, again setting a fresh record high.

Overall volume in the NYSE was 4% lighter than the previous
day’s level, while volume in the Nasdaq declined by 3%. It was the second
straight day of gains on lighter volume, but at least turnover in both exchanges
exceeded 50-day average levels. The gains on lower volume prevented the major
indices from registering a bullish "accumulation day." This was also the case
last Thursday, when the Nasdaq and S&P 500 gained an impressive 1.6% and 1.0%
respectively, but did so on lighter volume. Market internals were solid in the
Nasdaq, as advancing volume exceeded declining volume by a margin of 2.7 to 1.
The NYSE ratio was positive, but only by approximately 3 to 2.

Going into this week, there are several technical factors that
could provide a good excuse for stocks to correct or at least take a break.
Perhaps the most important is the Nasdaq’s upcoming test of resistance at its
52-week high. As you know, both the S&P and Dow are well beyond their prior
highs from May, but the laggard Nasdaq has only now rallied up to that pivotal
level. As illustrated on the weekly chart below, the Nasdaq finished last week
only 0.5% below its closing 52-week high of 2,370 that was set on April 19:

Because a 52-week high is always a closely-watched level,
expect a lot of volatility this week. Many stop orders are likely to be found in
this vicinity of the Nasdaq’s high, which would result in whippy intraday
trading action. If you’re long the Nasdaq and are planning to sell into
strength, now is a great time to do so. At the very least, tighten your trailing
stops using intraday trendlines and support/resistance levels. Sure, the Nasdaq
could easily break out to a new high, but you can simply re-enter your positions
on the first subsequent pullback.

Another factor that could provide the "cause for a pause" is
the Dow’s impending test of the 12,000 price level. Curiously, the actual 12,000
level does not provide any technical resistance because the Dow is at an
all-time high. But large, round numbers always act as "psychological resistance"
that becomes a self-fulfilling prophecy when traders sell into those numbers.
Back in 1999, for example, I remember the first time the Dow approached the
10,000 price level. Like the present time, the Dow was trading at an all-time
high, so there was technically no overhead resistance. Nevertheless, the index
tried and failed to break above the 10,000 level for a three-week period before
finally doing so. This is illustrated on the daily chart of the Dow from 1999:

When the Dow initially approached the 10,000 level, all the
financial media outlets such as CNBC and Bloomberg were hyping the possibility
of the Dow trading over 10,000 for the first time ever. Had that not been
the case, the Dow probably would have popped over 10,000 much faster than it
did, but all the hype created a self-fulfilling prophecy of "psychological
resistance" that held the Dow below 10,000 for three weeks. Over the weekend, we
read a lot of hype about the Dow being near the 12,000 level, so we believe this
is likely to cause a bit of resistance for the Dow. The index closed last week
at 11,960. so we could see that probe above the 12,000 level as early as today.

The Semiconductor Index ($SOX) is once again approaching
resistance of its 200-day moving average, which also converges with resistance
of its prior high from last month. This laggard index began to show signs of
life last week, but keep a watchful eye trained on that 200-day moving average.
As the $SOX goes, the Nasdaq tends to follow, so be on alert for a reversal of
the $SOX at its 200-day MA:

Finally, remember that the S&P 500 is sitting right at its
76.4% Fibonacci retracement level from it March 2000 high down to its October
2002 low. As discussed in the October 13 issue of
The
Wagner Daily, this is the "last line of defense" that could stop the
index from following the Dow by blasting off to a new record high. Momentum has
pushed both the S&P and Nasdaq above the upper channel of their uptrend lines on
the daily charts, which has caused our near-term bias to become neutral
to bearish, but the charts of the S&P and Dow give us every reason to remain
bullish on the intermediate term. Don’t forget that quarterly earnings season is
also kicking into full swing and could provide yet one more reason for excessive
volatility in the short-term.

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 .