Russell 2000 Looks to be Heading Lower

The stock market concluded the first
week of the new year on a negative note, causing most of the major indices to
close at their lowest levels in more than a month.
After gapping down on the open, stocks trended lower throughout the morning
session, stabilized at mid-day, then traded in a sideways range throughout the
afternoon. The S&P 500 fell 0.6%, the Dow Jones Industrial Average 0.7%, and the
Nasdaq Composite 0.8%. Although strength in the techs enabled the Nasdaq to show
surprising relative strength the previous day, this time the index moved lower
alongside of the S&P and Dow. Small and mid-cap stocks suffered the worst
losses, as the Russell 2000 plummeted 1.8% and the S&P Midcap 400 declined 1.1%.

The only positive thing about last Friday’s session is that
the losses occurred on slightly lower turnover. Total volume in the NYSE
declined by 1%, while volume in the Nasdaq was 5% lower than the previous day’s
level. If volume had increased instead, it would have been the second
“distribution day” within three sessions. Nevertheless, the higher than average
volume levels showed that institutional selling was not completely absent.
Market internals were firmly negative as well. In the NYSE, declining volume
exceeded advancing volume by a margin of nearly 3 to 1. The Nasdaq ratio was
negative by 2.3 to 1.

The new year got off to a choppy start with the erratic and
indecisive price action of January 3 and 4, but finished the week decidedly
lower. Though the Nasdaq held up well and even secured a gain last week, the
other indices are starting to look rather bearish on their daily charts. The
small-cap Russell 2000 Index, typically a leading indicator of the broad
market’s health, closed below its 50-day moving average for the first time since
the current uptrend began back in August of 2006. Throughout December, it
touched and bounced off support of its 50-MA on four separate occasions, but
each subsequent test weakened the support level until it finally broke down last
Friday. This is illustrated on the daily chart of the Russell 2000 below:

Over the past several years, monitoring the performance of the
Russell 2000 has become very important because the index has led the other
indices in both bullish and bearish reversals. In the first several years of the
new millennium, traders found that the Semiconductor Index ($SOX) was one of the
best leading indicators of the overall market’s health, but that has changed in
recent years. While the direction of the heavily weighted $SOX is still
important, the index has lost a lot of its luster as earnings growth in most
chip companies has slowed. Instead, institutional money flow into small-cap
companies, typically focused on aggressive earnings growth, has become an
accurate way to determine the level of confidence institutional traders have in
the state of the market. The $SOX index, for example, has been trading in a
wide, sideways range since 2003, but the Russell has been trending steadily
higher over the past three years, continually setting new all-time highs. The
S&P Midcap 400 Index has become a similar leading indicator, which is why we
discuss the performance of both the Russell and S&P Midcap indices on a daily
basis. The S&P Midcap 400, which we remain short via the UltraShort MidCap 400
ProShares
(
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PowerRating), also closed below its 50-day MA last Friday:

The benchmark S&P 500 is still above its 50-day MA, but has
begun to roll over as well. As you can see, the index closed at lowest level of
the past four weeks and now has overhead resistance of its 20-day MA. Watch
closely to see how the S&P reacts on the likely test of its 50-day MA:

The Dow Jones failed its rally attempt to a new record high on
January 3, trapping the bulls who bought the intraday breakout. It then closed
last week just below support of its primary uptrend line that has been in place
since the low of July 2006. A break below last Friday’s low will confirm the
break of trendline support, which would subsequently lead to a test of the Dow’s
50-day MA in short order:

Thanks to its solid gain on January 4, the Nasdaq Composite is
still above its 50-day MA, but trading action has been very choppy. Unless the
index makes a clean break below last week’s low of 2,394, we recommend avoiding
the indecisive Nasdaq for now.

When the broad market is trending steadily in one direction or
the other, the broad-based ETFs are ideal trading vehicles. Conversely, choppy,
sideways markets are better suited for trading specific industry sectors with
relative strength or weakness to the broad market. When the major indices were
range-bound in December, we focused on ETFs with the most relative strength and
weakness to the major indices, as opposed to the broad-based ETFs. However, it
appears that a “changing of the guards” is taking place, which is causing the
market to begin a new trend lower. Obviously, it’s impossible to know how long
the current correction will last, but we plan to trade the broad market on the
short side as long as it does. If the bearish action in the Russell and S&P
Midcap remains an accurate forecast of things to come, astute traders will take
that as a serious warning sign to entering new long positions. Finally, remember
that the new ProShares ETFs are a better way to trade the broad market on the
short side because they can be traded in a cash account (such as an IRA), and
they also provide leverage that enables you to capture more volatility with less
buying power. The traditional SPY, DIA, and QQQQ are losing market share to the
ProShares ETFs, and we certainly understand the reasons why, especially for
short-term traders.

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 .