Sentiment Has Drastically Changed

Stocks gapped slightly higher in an
attempt to follow-through on last Friday’s modest rebound, but traders
immediately sold into strength, sending the broad market sharply lower in the
morning session. The major indices stabilized in the afternoon, but
recovered only a small percentage of the morning losses. The Nasdaq Composite
slid 0.8%, the Dow Jones Industrial Average 0.7%, and the S&P 500 0.5%. The
small-cap Russell 2000 fell 0.9% and the S&P Midcap 400 lost 0.5%.

The one positive about yesterday’s session is that the
broad-based losses occurred on lighter volume. Total volume in the NYSE declined
by 10%, while volume in the Nasdaq was 4% lower than the previous day’s level.
Yesterday’s lighter volume enabled the Nasdaq to dodge what would have been its
fourth “distribution day” within the past four weeks, but market internals were
nevertheless bearish. In the Nasdaq, advancing volume exceeded declining volume
by a ratio of 4 to 1. The NYSE ratio was negative by 2.2 to 1. Keep a close eye
on the running count of bearish “distribution days” because four or more days of
higher volume selling within a one-month period typically causes even the
strongest markets to suffer a substantial correction. In addition to two
consecutive days of institutional selling last week, the Nasdaq also registered
a “distribution day” on December 29. The S&P 500 has had two “distribution days”
within the past four weeks.

While many ETFs have begun to exhibit substantial signs of
weakness, one ETF that has been largely ignoring the broad market is the
Biotech HOLDR
(
BBH |
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News |
PowerRating). Since breaking out to a new 52-week high on January
11, BBH has been trending steadily higher in an orderly fashion. We were waiting
for a few days of sideways price action in order to take a position on the
pullback, but it never came. However, BBH formed a bearish candlestick
yesterday, indicating that it may finally be poised for a short-term correction.
It gapped open above the previous day’s high, then rallied on the open, but sold
off in the afternoon and closed at its intraday low. The end result was the
formation of an “inverted hammer” candlestick, a pattern which often precedes a
short-term top. Our plan is to buy BBH on a pullback to support of its breakout
level, not to call a top and sell it short. As you can see on the daily
chart below, the $193.25 area marks support of the breakout level (which was
prior resistance). A retracement down to this level within the next few days
will constitute a low-risk entry point on the long side of BBH. As long as the
Nasdaq doesn’t completely fall apart from here, we plan to buy BBH on such a
pullback:

Another ETF we are watching on the long side is the
StreetTRACKS Gold Trust
(
GLD |
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PowerRating), which roughly trades at 1/10 the price of
the spot gold commodity. GLD got off to a rough start this month, losing nearly
5% in the first three trading days of the year, but it has been grinding its way
back since then. Now, it is again within striking range of breaking out above
its eight-month downtrend line. A rally above yesterday’s high would represent
such a breakout. This is illustrated on the long-term weekly chart below:

In yesterday’s newsletter, we mentioned that we were remaining
alert for a potential break of the 50-day moving averages in both the Nasdaq
Composite and Nasdaq 100 indices. Within the first hour of trading, both indices
had already done so, triggering our long entry in the UltraShort QQQ ProShares
(
QID |
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PowerRating).
More importantly than an intraday probe below their 50-MAs, both indices also
closed below that pivotal support level. The last time the Nasdaq Composite
finished below its 50-day MA was on December 22, but it snapped back above it
the next day. Since it closed below its 50-MA by only a small margin yesterday,
it could do the same thing again today. However, as we mentioned yesterday, the
overhead supply created from last week’s failed breakout may make it more
difficult for the Nasdaq to recover this time. A close below yesterday’s
intraday low of 2,422 (1,771 for the Nasdaq 100) should confirm a break of the
50-day MA.

Within a very short period of time, the sentiment and dynamic
of the stock market has drastically changed. Two weeks ago, the Nasdaq firmly
broke out to a new six-year high, fueled by strength in leading stocks like
Apple
(
AAPL |
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PowerRating) and Google
(
GOOG |
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PowerRating), as well as a breakout in
the Semiconductor Index ($SOX). But now the Nasdaq has failed its breakout and
is already back below its 50-day MA. Worse is that the $SOX has broken its
200-day MA. Former leaders like Apple, which has shed 10% in the past four
sessions, have started to come unglued. Why the sudden change of heart? Thank
our good friend, quarterly earnings season. We warned of putting too much faith
in technical chart patterns during earnings season, and the current environment
is a perfect example of why we have been so cautious on the long side. A
plethora of additional earnings reports are on tap over the next week, so stay
on your toes!

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 .