Institutional selling is most useful at market tops
The major indices got off to a
positive start with decent opening gaps to the upside, but the bears
quickly took control and sold into strength, causing stocks to trend lower and
close with moderate losses. As we have seen on most of the “down” days in recent
months, small and mid-cap stocks fell the most. The Russell 2000 lost 1.3% and
the S&P Midcap 400 dropped 1.0%. The Nasdaq Composite and S&P 500 closed lower
by 0.8% and 0.4% respectively, but the Dow Jones Industrial Average managed to
finish unchanged.
Total volume in the Nasdaq rose by 3% yesterday, but the NYSE volume level was
about the same as the previous day. The Nasdaq’s loss on higher volume added
another “distribution day” to the count. The fact that stocks continue to fall
on increasing volume confirms our bearish sentiment on the overall market. Until
we begin to see light volume on the “down” days and higher volume on the “up”
days, it doesn’t make sense to get excited about buying stocks. Keeping track of
institutional selling is most useful for detecting market tops in advance of the
crowd, but it is also useful for confirming the underlying strength of any
broad-based selling when in a solid downtrend. Market internals spent the first
half of the day in positive territory, but finished negative. In both exchanges,
declining volume exceeded advancing volume by a ratio of 1.7 to 1. This was not
too bad, but it’s bearish that the internals reversed from being positive
earlier in the session.
It’s interesting to note that yesterday’s 0.8% loss in the Nasdaq occurred
despite a 1.1% gain in the Semiconductor Index ($SOX). The $SOX finally bounced
from oversold conditions and was showing a 3.0% gain at its intraday high, but
broad-based selling in the afternoon caused the index to give back most of its
gain. The $SOX was one of only three industry sectors that closed in the green
yesterday. The other two were the Broker/Dealer Index ($XBD) and the Telecom
Index ($XTC), both of which gained the same as the $SOX. Because the
semiconductor stocks are so heavily weighted within the Nasdaq, the strength in
the $SOX helped mask the true weakness in the Nasdaq, which would have closed
much lower if the $SOX had not bounced. The $SOX may be trying to put in at
least a short-term bottom, but it still remains below resistance of its primary
downtrend line. We would not touch the semis on the long side until the $SOX at
least breaks out above its downtrend line. Even then, overall broad market
conditions could dictate staying positioned fully on the short side of the
market. As you can see on the daily chart of the $SOX below, the primary
downtrend line (the dashed red line) converges with the 20-day moving average
(the beige line). You may want to keep an eye on that convergence of resistance
because a breakout above that level could trigger a lot of short covering and
some tradeable momentum on the upside:
Because they are considered to be more “aggressive” investments than large-cap
stocks of established companies, the small and mid-cap stocks tend to lead the
broad market in both directions. When in a bull market, the gains in the small
and mid-cap indices will usually outpace the gains in the S&P and Nasdaq on the
“up” days. Conversely, a conservative “flight to safety” mentality usually
causes both sectors to lead the market lower when the stock market is weak. We
always pay careful attention to the technical patterns of both the Russell 2000
and S&P Midcap 400 indices because they tend to lead the market in both
directions. When studying their charts over the past several days, we noticed
that both indexes are in the process of completing the right shoulder of a
bearish “head and shoulders” chart pattern. Below, we have illustrated this
chart pattern on the daily chart of the iShares Russell 2000 Index (IWM):
On the right shoulder, notice how IWM has formed kind of a double right shoulder
by bouncing off the low of July 21. The double right shoulder indicates a bit of
resilience because the bulls stepped in when IWM tested support of the neckline
both times. It is noteworthy to be aware of this. However, a confirmed break of
the neckline should result in a rapid burst of selling momentum. More aggressive
traders may consider selling short a partial position of IWM just below
yesterday’s low, then adding to the position on confirmation of the break of the
neckline. A logical protective stop is over the high of the right shoulder, as
the 200-day MA has been acting as firm resistance. If IWM does break below its
neckline, the price target would be equal to the distance from the top of the
head down to the neckline. In this case, that equates to a drop of approximately
six points below the neckline. That would put IWM down to the $60 level which,
curiously, equates to support of the October 2005 low. The S&P Midcap 400 SPDR (MDY)
has a similar chart pattern to IWM, so the trigger is below its neckline, stop
above the right shoulder, and target of distance from the top of the head down
to the neckline.
We showed you the head and shoulders patterns on MDY and IWM not only because
they are good potential short setups, but also because their patterns say a lot
about the market’s overall health right now. You can be assured that IF they
follow through and break their necklines, the momentum will lead all the other
indices much lower as well. Until the market proves otherwise, long is still
wrong!
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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 .