Stalking Short Positions in the Retail Sector

A broad-based bounce in the stock
market enabled the Nasdaq to snap its five-day losing streak yesterday, but
volume fell to its lowest (regular session) level of the year. Stocks
opened marginally higher, chopped around in a lazy, sideways range throughout
the day, then edged slightly higher in the final thirty minutes of trading. The
Nasdaq Composite, Dow Jones Industrial Average, and S&P Midcap 400 indices each
gained 0.5%, while the S&P 500 advanced 0.4%. The small-cap Russell 2000 once
again bounced off support of its 50-day moving average, registering a gain of
0.9% in the process. Each of the major indices closed near their intraday highs
for a change, but the S&P and Nasdaq both failed to even test their previous
day’s highs.

Turnover dropped to extremely low levels yesterday, indicating
traders are more focused on enjoying the rest of the holiday season than jumping
back in the market right after the Christmas holiday. In both exchanges, total
volume was 20% lighter than the previous day’s levels. Excluding the shortened
sessions of July 3 and November 24, it was the lightest volume day of the year
in both the NYSE and Nasdaq. Given that this week is traditionally the slowest
of the year, the lethargic turnover was no surprise. Again, it will be difficult
to determine the true underlying health of the market until we see the return of
institutional activity. Most likely, this won’t happen until next week, after
the New Year’s Day holiday has passed.

Because of its seasonal volatility, the Retail Index ($RLX) is
one sector we are following closely right now. Less than stellar holiday sales
have caused the index to fail its recent breakout to a new all-time high.
Further, many high flying retail stocks to begin seeing distribution that will
could easily cause the $RLX to correct significantly further from here. Looking
at the chart below, notice how the $RLX failed its mid-December breakout attempt
and is now consolidating in a narrow range, below support of its 50-day MA:

With the index closing lower in five of the past six trading
days, the $RLX could bounce or trade sideways for a while before going lower,
but it looks like the sector is in trouble. More important than the 20 and
50-day moving averages now acting as overhead resistance is the fact that the
index failed its breakout of a long base of consolidation. In weak markets, we
have found that failed breakouts to new highs are one of the most profitable
shorting strategies. This happens because the bulls who bought the new high are
quickly forced to dump their shares, which in turn attracts the short sellers
who detect the weakness. However, there are two caveats to this type of setup.
First, the breakout attempt to a new high must have been from at least a
multi-week base of sideways consolidation, as opposed to a parabolic trend. The
$RLX obviously qualifies on this accord. Second, we wait for a breakdown below
the low of its prior consolidation in order to have confirmation of the bearish
reversal. In this case, a breakdown below yesterday’s low would represent a
break below the recent range. If downward momentum in the $RLX index continues,
it’s not unrealistic to assume a price target of the 200-day MA, presently at
the 468 level.

If you wish to capitalize on the relative weakness in the
Retail sector, there are several ways. First, you can obviously select the
individual stocks within the sector that possess the weakest chart patterns.
Ticker symbols of a few retail stocks we are already short in our hedge fund
are: AEOS, SHLD, JCP, and ANF. Second, of course, are the Retail ETFs. The
Retail HOLDR
(
RTH |
Quote |
Chart |
News |
PowerRating) is perhaps the most well-known, but we do NOT like it for
a short setup here. The problem with RTH (and all the HOLDRS) is that they are
comprised of only 20 individual stocks. Worse is that they were the leading
stocks of years ago, not today. Better alternatives may be found with the
StreetTRACKS Retail
(
XRT |
Quote |
Chart |
News |
PowerRating) and the S&P Select Consumer Discretionary SPDR
(
XLY |
Quote |
Chart |
News |
PowerRating).

In yesterday’s newsletter, we pointed out several key
technical events that occurred in last Friday’s session: the Nasdaq Composite’s
marginal break of its 50-day MA, the second test of the 50-day MA support for
the Russell 2000, and the third test of the 200-day MA within the past month for
the Semiconductor Index ($SOX). As if on cue, each of those indices staged
obligatory bounces at these pivotal support levels. Yesterday’s rally pushed the
Nasdaq back above its 50-MA, but the reversal attempt lacked overall momentum.
We would not be surprised to see a choppy, narrow range throughout the rest of
this week, but we expect a lot of volatility when traders return to “business as
usual” next week. Keep watching the major support levels in the three indices we
illustrated yesterday in order to determine the most likely direction the
volatility will go.

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 .