Room to bounce, but here’s what I recommend…

The Nasdaq Composite snapped its
eight-day losing streak
, as the major indices posted a session of
solid gains yesterday. Stocks drifted sideways to lower throughout most of the
day, but buyers stepped in during the final thirty minutes and enabled the major
indices to finish near their intraday highs. The Nasdaq Composite
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gained 0.7%, the S&P 500 rallied 0.5%, and the Dow Jones Industrial Average
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advanced 1.0%. The small-cap Russell 2000 and S&P Midcap 400 indices closed
higher by 0.7% and 0.5% respectively.

Unfortunately for the bulls, turnover fell across the board.
Total volume in the NYSE was 14% lighter than the previous day’s level, while
volume in the Nasdaq declined by 15%. A session of gains on higher volume would
have hinted at institutional buying interest, but a rally on lighter volume
should be viewed with a suspicious eye when the markets are in such a firm
downtrend. Nevertheless, yesterday was still a reversal attempt and could lead
to a better performance in the next day or two. We’ll be closing watching the
market’s relationship between price to volume in order to determine whether or
not we are seeing any legitimate signs of institutional demand or merely a
technical bounce from the selloff. Market internals were positive yesterday, as
advancing volume exceeded declining volume by a ratio of approximately 2 to 1 in
both exchanges.

As of the time of this writing, both the S&P and Nasdaq
futures are gapping higher in the pre-market. If the gap holds, the major
indices will be poised to open above yesterday’s highs, which could result in a
bit of upward momentum off the lows. Obviously, the broad market remains firmly
in an intermediate-term downtrend, but stocks could still bounce significantly
without technically violating the current downtrend. The positive is that the
downtrend of the past five weeks has formed clearly defined trendlines that will
act as resistance. If you wish to play the bounce with the broad-based ETFs, it
is important that you are aware of the levels at which the major indices will
run into that resistance. Therefore, let’s take an updated look at where the
downtrend lines (the dotted blue lines) are positioned on the charts. Below are
daily graphs of the S&P 500 SPYDER
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, Nasdaq 100 Index Tracking Stock
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,
and the Dow Jones DIAMONDS
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. SPY is first:


The primary downtrend line in SPY begins with the highs of May 10. If SPY
rallies up to resistance of that downtrend line, it will probably have also
converged with resistance of the 200-day moving average (the orange line) in the
same vicinity. The convergence of both a five-week downtrend line AND a 200-day
moving average will act as powerful overhead resistance, so we clearly view any
rally into that area as a chance to sell long positions and perhaps initiate new
short positions. Next, take a look at QQQQ:


Comparing the charts of QQQQ and SPY, you can easily see the relative strength
that the Nasdaq had ahead of the S&P’s May selloff. Notice how QQQQ was already
below its multi-year high when the selloff in the S&P began on May 10. But in
keeping with comparison of the same timeframe as the S&P selloff, we have drawn
the trendline from the May 10 high. Notice how the 20-day moving average
converges in the same area as the downtrend line. This is also the case with DIA:



As you can see, each of the three broad-based ETFs above have
a bit of room to bounce before running into any major resistance. However, we
strongly recommend that long positions be sold into strength on any rally into
resistance of those downtrend lines. Obviously, the downtrend lines could be
broken at any time, but our job is to analyze and react, not predict when
current market trends will change. Accordingly, we must assume the downtrend
lines of the past five weeks will remain intact until the market proves
otherwise. For now, we think any long positions need to be entered with the
mindset of being short-term counter-trend trades. But if the major indices
generate enough power to break their downtrend lines, then we will simply
re-assess market conditions and determine which sectors are showing the most
relative strength. Until that happens, we will remain mostly positioned in cash,
holding off on new short entries, and perhaps testing the waters on the long
side of the market, albeit with a brief time horizon.


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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
.