If we see some selling, this sector should lead the way

Stocks began last Friday’s session in
positive territory, but a selloff that began at
mid-day caused the major indices to close lower across the board. Once again,
tech and mid-cap stocks showed the most relative weakness, which is not a good
sign for the markets. The mid-cap S&P 400 Index
(
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PowerRating) shed 0.5%, while the
Nasdaq Composite
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small-cap Russell 2000 0.2%, and the Dow Jones Industrials
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Each of the major indices closed near their intraday lows, indicating a lack of
institutional demand. For the week, the broad market turned in mixed results.
The S&P 500
(
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PowerRating) gained 0.5%, but the Nasdaq Composite lost 0.2%. The
Russell 2000 fared the worst of the bunch, dropping 0.8% for the week.

Total volume in both exchanges surged higher last Friday,
adding another "distribution day" for both the S&P and Nasdaq. Total volume in
the NYSE was 28% higher, while volume in the Nasdaq increased substantially by
33% over the previous day’s level. To be fair, part of the increase in volume
was likely attributed to the quarterly "quadruple witching" of options
expiration on Friday. Nevertheless, the losses on higher volume caused the broad
market to register its fifth day of institutional selling within the past
four weeks. A healthy market can typically absorb two or three "distribution
days" within a four-week period, but a fifth day of distribution within that
time period is definitely an important warning sign to the bulls. Remember that
volume tells us what is really happening "under the hood" of the markets. Daily
analysis of the relationship between price and volume is also important because
volume typically leads price, thereby giving us an early advantage at spotting
potential trend reversals in the broad market. Without even looking at any
charts, the recent pattern of "distribution days" alone should give the bulls
cause for a pause.

Looking at the broad market, we feel that caution is required
on the long side right now. In addition to the recent trend of "distribution
days," a few of the major indices are beginning to lose support of their
consolidations on the daily charts. The small-cap Russell 2000 Index, typically
a leading indicator of broad market direction, has already broken support of its
daily uptrend line. It also closed below its 20-day moving average for the first
time since October 28, the same week the current rally began. Below is a chart
of IWM, the iShares ETF that closely mirrors the Russell 2000:

The longer-term weekly chart of IWM also shows that the index
never broke out to a new 52-week high when the S&P and Nasdaq both did. IWM is
trading back below its prior high from August 3, which confirms the relative
weakness we have been discussing:

As you know, prior support becomes the new resistance after
the support is broken, so we now expect the prior uptrend line (the red
ascending line on the first chart) to provide resistance on any rally attempt.
There has not been enough confirmation to cause us to be aggressively bearish on
the overall market yet, but we feel IWM could lead the way lower if and when
stocks begin to see more selling from here. Regular subscribers will notice we
are stalking IWM for a potential short entry if it trades through our trigger
price in the coming week.

Like the Russell 2000, the mid-cap S&P 400 Index also closed
last Friday below its 20-day MA for the first time since October. Below is a
chart of MDY, the ETF that mirrors the S&P 400:

Although a few of the indices are beginning to show weakness
on their daily charts, bear in mind that both the S&P and Nasdaq are holding
near their respective multi-year highs. Because both indices lack overhead
supply, it would require only minimal buying pressure to push them to new highs
from here. If that happens, the Russell 2000 and S&P 400 would probably go along
with them. This means the major indices are presenting mixed signals right now
and the most likely outcome is choppy trading conditions until the market
resolves itself one way or the other. As such, it is not a good time to
be aggressively entering new positions from here. If, however, you do take on
new positions, be sure to reduce your position size because the markets are
likely to become more erratic as we near the Christmas and New Year holidays.

Open ETF positions: