NASDAQ and SOX at Critical Levels

Stocks posted another session of
losses last Friday, causing several of the major indices to break below key
support levels ahead of the holiday weekend. Both the Nasdaq
Composite and Dow Jones Industrial Average lost 0.6%, while the S&P 500 shed
0.5%. The small-cap Russell 2000 declined 0.3% and the S&P Midcap 400 closed
0.4% lower. Each of the major market indexes finished at their intraday lows
and at their worst levels of the week. For the week, the Nasdaq Composite
slid 2.3%, the S&P 500 1.1%, and the Dow Jones 0.8%. Not only did the Nasdaq
give back a sizeable portion of its recent gains, but the index also posted
losses every day last week.

As expected, volume was rather tepid ahead of the extended
holiday weekend. Total volume in the NYSE declined by 27%, while volume in the
Nasdaq was 25% lighter than the previous day’s level. The S&P and Nasdaq have
both posted losses in each of the past three days, but each session has posted
declining volume. This is positive because it indicates a lack of institutional
distribution, but many traders were absent from their desks ahead of the holiday
weekend anyway. Therefore, the losses on lighter volume may be a bit deceiving.
Unfortunately, volume is unlikely to pick up again until after the New Year’s
Day holiday has passed. Price action has been negative lately, but it will be
difficult to determine the market’s true underlying health until volume returns
to the markets next week.

Despite the low turnover, several important technical events
occurred last Friday. Most notable was the Nasdaq Composite’s close below the
50-day moving average for the first time since the current uptrend began back in
mid-August. Since the index broke support of its primary uptrend line early last
week, it’s not surprising that it fell below its 50-day MA a few days later. We
have illustrated this on the chart below:

Because the Nasdaq closed below this pivotal moving average
only one day so far, we can not declare an “official” break of the 50-day MA.
Often, an index will dip below key support levels such as the 50-day MA, run all
the sell stop orders, then pop back above it the next day. However, even if the
Nasdaq attempts to move back above its 50-MA, firm overhead resistance has now
been established at the prior uptrend line. The 20-day MA should also provide
resistance. Remember that a prior support level becomes the new resistance level
after the support is broken. Since we are positioned in the UltraShort QQQQ
ProShares
(
QID |
Quote |
Chart |
News |
PowerRating), currently showing a solid gain, we will be on alert for a
failed breakdown in the Nasdaq. If we detect strong buying programs near the
50-MA, we will tighten our stop to reduce risk.

The Russell 2000 Index, a leading indicator of the broad
market’s health, bounced of support of its 50-day MA on December 19. However, it
ran into overhead resistance of its 20-day MA and prior uptrend line the
following day. Two days later, it has once again closed right at the 50-day MA.
With such a feeble rally attempt off the 50-MA, it would not take a lot of
selling pressure to cause the Russell to break below its 50-MA in the coming
days. In case you are interested in shorting a breakdown, the iShares Russell
2000
(
IWM |
Quote |
Chart |
News |
PowerRating)is the ETF that tracks the index:

In the

December 14 issue of
The
Wagner Daily, we pointed out how the Semiconductor Index ($SOX) had
closed at major support of its 200-day moving average. We explained why it was
likely to bounce at that level, which it did, but also mentioned that a mild
bounce would only put the index in the middle of its range (“no man’s land”).
Two weeks later, the $SOX has once again closed at support of its 200-day MA:

When a stock or index tests support of its 200-day MA on
several occasions within a short period of time, each subsequent test increases
the odds of a breakdown. Since this is the third time the $SOX has tested its
200-day MA this month, we are definitely on alert for a potential breakdown
below the 200-MA this time. If that happens, it will obviously have a negative
effect on the chip-heavy Nasdaq Composite. The $SOX tends to lead the Nasdaq,
which in turn leads the S&P and Dow.

Given the close proximity of both the $SOX and the Nasdaq to
the key support levels illustrated above, it is risky to initiate new short
positions at current levels. If you’re already short, just keep trailing your
stops lower, perhaps above the hourly downtrend lines, in order to protect your
gains. If you’re long, consider selling your positions into strength of the next
bounce. If the Nasdaq manages to climb back above its 20-day MA and prior
uptrend line, you can buy back into your positions. But if the Nasdaq bounces
and begins to roll over again, you can dump any remaining long positions, then
initiate new short positions at a low-risk price level.

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 .