Out Of 3 Major Indices, 2 Are Ready To Be Shorted…Here’s Why

Stocks opened on a higher note
and trended higher throughout the morning session, but a negative reaction to
tech giant Cisco’s earnings report weighed heavily on the Nasdaq all day.
Relative weakness in the Nasdaq acted as an anchor on the S&P and Dow, which
subsequently caused each of the major indices to reverse their trends in the
afternoon and post losses on higher volume. Both the S&P 500 and Dow Jones
Industrials lost only 0.2% yesterday, but the Nasdaq Composite slid 0.8%. The
S&P 400 Mid-Cap Index eked out a 0.1% gain, while small cap stocks of the
Russell 2000 closed lower by the same percentage.

More important than the bearish intraday price action of the
broad market was that yesterday’s losses occurred on higher turnover. Total
volume in the Nasdaq surged 24% yesterday, due largely in part to Cisco’s volume
spike to 202 million shares. Volume in the NYSE was 9% higher than the previous
day’s level. The broad market’s losses, combined with a strong uptick in volume,
means that yesterday was a confirmed “distribution day” in both exchanges.
Although the major indices have closed lower in three of the past four days,
yesterday was the the first clear day of institutional selling since the
widespread correction began on August 4.

FXI, which is the ETF that tracks China’s Xinhua 25 Index,
once again blasted off to a new high and marked a 2.6% gain yesterday. Volume in
FXI also spiked to 2.5 times its average level. A new high in the price of Crude
Oil also fostered strength in OIH (Oil Service HOLDR), which gained 1.8% and
closed at a fresh all-time high. As we have been anticipating, the Gold and
Silver Index ($XAU) also showed strength and enabled GLD (Gold Trust) to move
0.8% higher. Most sector ETFs, however, closed flat to lower. RTH (Retail HOLDR)
came within 25 cents of our stop when it rallied yesterday morning, but it sold
off sharply in the afternoon and closed fractionally lower. SMH (Semiconductor
HOLDR) hit our updated trailing stop of $37.10 yesterday, which locked in a gain
of nearly 7% on the remaining shares.

Following a similar pattern of many sectors yesterday, UTH
(Utilities HOLDR) opened higher and was showing a 1.5% gain at its morning high,
but overhead supply from the recent selloff caused it to reverse and close only
0.1% higher. After coming into support of its 50-day moving average three days
ago, UTH should have closed strong, but the less powerful 20-day MA acted
as resistance instead. Many leading stocks within the Utilities sector are
showing bearish chart formations as well, so we feel UTH is headed for a break
down below support of its 50-day MA within the next week. As such, we shorted
UTH at mid-day yesterday and sent an intraday e-mail alert to inform subscribers
of the trade entry and stop price. If have been long the Utilities sector for
any decent length of time, you are probably sitting on a healthy profit, but we
recommend you tighten your stops to protect those gains in case of an
intermediate-term trend reversal that would result from institutional sector
rotation.

Yesterday morning’s broad-based rally attempt that failed in
the afternoon caused the major indices to form some rather bearish looking
candlestick patterns on their daily charts. The Dow Jones Industrial Average,
for example, briefly broke out above its four-week trading range in the morning,
but fell down a few hours later and closed back below its 20-day moving average.
This puts the Dow back in the choppy area of “no man’s land,” but close to
breaking below support of its 50 and 200-day moving averages. If the index does
break support of these moving averages within the next few days, we will
probably enter a new short position in DIA (Dow Jones Tracking Stock). The daily
chart of the Dow below illustrates the failed breakout attempt and close
proximity to the break of moving average support:

Like the Dow, the S&P 500 initially looked great yesterday
morning, as the index had powered through resistance of its 20-day moving
average and came to within only three points of last week’s highs. But
unfortunately for the bulls, it too fell victim to the bears in the afternoon
and finished the day back below its 20-day moving average. Worse is that the
failed rally of the morning trapped the bulls who did not quickly sell when the
index headed south in the afternoon. Sharp intraday reversals such as
yesterday’s create overhead supply that makes it difficult for the market to
gain any ground, even if it attempts to rally again the next day. Looking
at the chart of the S&P below, notice the long “tail” or “wick” on yesterday’s
candlestick that was created by the failed intraday rally attempt and subsequent
reversal:

Going into yesterday, the Nasdaq had the best looking daily
chart of the major indices, but that has changed now as well. While the S&P and
Dow were rallying steadily throughout the first ninety minutes of the day, the
Nasdaq failed to keep pace. Conversely, the index indicated relative weakness to
both the S&P and Dow by merely trading sideways instead. When conditions
deteriorated in the afternoon, the Nasdaq was the first index to drop and it
also fell the hardest. The 0.8% loss in the Nasdaq caused the index to set a new
3-week low, but the index is also coming into support of its daily uptrend line
that began with the low of April 29. Look for a test of this trendline support
(the ascending blue line) within the next several days:

Because of the Nasdaq’s trendline support shown above, we do
not yet recommend shorting QQQQ or other Nasdaq-related ETFs. However,
the Dow and S&P may soon be primed for shorting. Remember the one thing that was
causing us to maintain a bullish overall bias, despite negative price action,
was that volume was coming in lower on each of the down day and rising on a
majority of the up days. However, yesterday’s bearish action has caused us to
shift to a neutral bias in the short-term. This means that your best bet is
probably to allocate a higher cash position right now. If, however, you feel the
need to stay in the market, consider positioning yourself on both sides of the
market. The best way to do this is by shorting the sector ETFs and stocks that
are showing the most relative weakness (Home Builders, Retail, Utilities, ) and
buying those with relative strength (Chinese ADRs, Gold, Oil and Oil Service).
The Morpheus Capital hedge fund now has an allocation of about 60% short and 40%
long, but now is a time to be alert and ready to change gears at a moment’s
notice.

Short RTH, short UTH, long EWA (regular subscribers to

The Wagner Daily receive detailed stop and target prices on open
positions and detailed setup information on new ETF trade entry prices. Intraday
e-mail alerts are also sent as needed.)

Deron Wagner

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 .