Look to the Nasdaq for Leadership

Stocks followed through on Monday’s
selloff with an opening gap down yesterday morning, but an afternoon recovery
enabled the major indices to close modestly higher. The S&P 500,
Nasdaq Composite, Russell 2000, and S&P Midcap 400 indices all gained 0.3%. The
laggard Dow Jones Industrial Average edged only 0.1% higher. It was positive
that the broad market reversed its opening losses, but the gains were minimal
considering the extent of the previous day’s losses. This was especially true of
the Nasdaq and Russell 2000, which suffered declines of 2.2% and 2.6%
respectively.

Total volume in both the NYSE and Nasdaq exchanges was 1%
lower than the previous day’s levels. Though turnover was nearly the same, the
absence of higher volume on the “up” day failed to confirm the presence of
institutional buying. A strong increase in volume and larger percentage gains
would have indicated traders were accumulating stocks beneath the surface, but
that wasn’t the case. Market internals were mixed, though much improved over the
previous session. In the NYSE, advancing volume exceeded declining volume by a
margin of 1.7 to 1. A weaker Nasdaq saw its advancing volume on par with
declining volume.

In yesterday’s newsletter, we mentioned that Monday’s break of
trendline support in both the S&P and Dow could not be confirmed by only one day
of closing prices. Rather, we wanted to see whether or not the S&P and Dow would
quickly snap back above their 20-day MAs and prior uptrend lines in yesterday’s
session. They didn’t, but the S&P could still do so today because the index
finished right at resistance of its 20-day MA and just below its prior uptrend
line. The Dow, however, may be a problem because it is still well below both its
20-MA and prior uptrend line. Here is an updated look at both indices:

Yesterday’s opening weakness caused the Nasdaq to test support
of its prior uptrend line, but it closed above it, as well as its 20-day MA:

Putting it all together, it seems that divergence between the
major indices may be increasing. The Dow is now well below its prior uptrend
line and barely bounced yesterday, but the Nasdaq is still within its trend
channel. If the stock market shows strength over the next few days, expect the
Nasdaq to lead the way higher, especially since the Semiconductor Index ($SOX)
is still (barely) holding its recent consolidation. Conversely, the Dow should
be a downside leader if the bears from Monday’s session return to the scene.
When the indices begin to diverge from one another, it often leads to choppy and
erratic overall trading conditions. Therefore, make sure your long positions are
in sector with relative strength and your short positions have relative
weakness. As the market shows its hand and makes its next move in the coming
days, we’ll be taking a look at which industries are likely to be both the
upside and downside leaders in the next phase. For now, our focus is on the
broad market because it is hinging on pivotal support levels.

Our open positions are all on the long side, but several are
not very correlated to the broad market. We remain long the StreetTRACKS Gold
Trust
(
GLD |
Quote |
Chart |
News |
PowerRating), which is consolidating at its highs and still acting well. We
like that GLD is directly tied to the price movement of the spot gold commodity,
not the stock market. We also are long the Oil Service HOLDR
(
OIH |
Quote |
Chart |
News |
PowerRating), which is
largely, but not fully, driven by changes in the price of crude oil. OIH came
close to our stop on Monday, but rallied back to near our entry point yesterday.
Our third long position, UltraShort Dow 30 ProShares
(
DXD |
Quote |
Chart |
News |
PowerRating), is basically a
short position in the Dow. This inversely correlated ETF should do well if the
relative weakness in the blue-chips remains. The PowerShares WilderHill Clean
Energy
(
PBW |
Quote |
Chart |
News |
PowerRating) is our remaining long position.

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 .