Stalking Shorts in the Retail Sector

Stocks concluded the week with
broad-based losses last Friday, but a late afternoon rally substantially reduced
the damage. The major indices trended lower throughout the morning,
attempted to recover at mid-day, but failed and dropped to new intraday lows
early in the afternoon. Though such action usually leads to a weak close, the
bulls took control in the final hour of trading, sending the broad market back
to near the mid-day highs. At its worst level, the Nasdaq Composite was off by
1.6%, but the index finished only 0.8% lower. The S&P 500 narrowed a 1% intraday
loss to only 0.3%. The Dow Jones Industrial Average lost only 0.2%, but the
small-cap Russell 2000 fell 0.6%. Curiously, the S&P Midcap 400 was unchanged.
All the indices except the Nasdaq Composite finished in the upper half of their
intraday ranges. The Nasdaq showed relative weakness by finishing just below the
middle of its range.

Turnover declined across the board, enabling the stock market
to dodge the bearish “distribution day” that would have occurred if the major
indices had registered losses on higher volume. Total volume in the NYSE was
sharply lower and came in 24% below the previous day’s level. In the Nasdaq,
volume declined by only 5%. While it’s positive that volume was lighter, it’s
important to note that volume actually dried up as stocks rallied in the final
hour. Prior to the closing rally, volume in the NYSE was on pace to be only 2%
below the previous day’s level. Volume in the Nasdaq was actually 6% higher.
This tells us the intraday selling pressure was significantly greater than the
end-of-day buying program. Many traders prefer to close short positions ahead of
weekends, so it’s not uncommon to see such action on otherwise weak Friday
afternoons. Market internals were negative throughout the entire day, recovering
only modestly into the close. In the Nasdaq, declining volume exceeded advancing
volume by a margin of nearly 4 to 1. The NYSE showed a better performance “under
the hood,” as its ratio was negatively by only 3 to 2.

We took the profit on our long position in the streetTRACKS
Gold Trust
(
GLD |
Quote |
Chart |
News |
PowerRating), as it moved very close to our original price target last
Friday morning, but then reversed lower intraday. We began buying GLD when it
began forming the right shoulder of an inverse “head and shoulders” pattern on
October 25. We subsequently added to the winning position on October 30 and
November 8, eventually giving us an average price of 59.84. We sold the full
position last Friday at 64.20, locking in a gain of 4.36 points (7.2%) above our
average price. Gold still looks strong, but it is likely to consolidate or
retrace a bit before moving much higher. The same goes for the oil and oil
service stocks, which is the reason we sold our Oil Service HOLDR
(
OIH |
Quote |
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News |
PowerRating)
position into strength on November 30.

Going into today, we are focused on resistance of the November
30 highs in each of the major indices. Many stocks have entered into short-term
downtrends that began with the broad-based November 27 selloff. The major
indices attempted to recover from the selloff from November 28 to 30, but each
index formed a “lower high” before selling off again on December 1. Therefore,
the November 30 intraday highs are technically significant because a rally above
those levels would invalidate the mini-downtrends that have begun to form.
Resistance of the November 30 highs is circled on the charts of the S&P, Dow,
and Nasdaq below. You may want to make note of these levels and set price alerts
on your trading platform:

As long as the S&P, Nasdaq, and Dow remain below their
November 30 highs, overall odds favor the downside of the market, at least in
the near-term. Note the operative word is “near-term” because all the
major indices are above their 50-day moving averages. It is risky to attempt
intermediate to long-term short positions without the major indices confirming
their trend reversal by falling below their 50-day MAs. Obviously, all short
selling bets are off, even in the near-term, if the major indices begin breaking
out above their November 30 highs.

Assuming stocks remains below the November 30 highs, we will
continue to gradually increase our exposure on the short side of the market.
Throughout last week, we mentioned that Banking ($BKX) and Retail ($RLX) are two
sectors that were poised to roll over to the downside. Based on Friday’s action,
this still seems to be the case. Overhead resistance of the 20 and 50-day moving
averages is becoming more significant in the $BKX, as the sector is barely
clinging to support of its prior low from November 3. If the broad market
weakness continues, Banking should be one of the sectors to lead the way lower.
This is the reason we recently sold short the Regional Bank HOLDR
(
BKH |
Quote |
Chart |
News |
PowerRating),
which has a very similar daily chart pattern to the $BKX index. One thing that
really caught our eye about RKH last Friday was its huge volume. As illustrated
below, RKH traded nearly 5 times its average daily volume:

Because ETFs are synthetic instruments, high volume will never
have a direct bearing on the direction of its price. Only changes in the prices
of the underlying stocks will affect the price of the ETF. Nevertheless, a
volume spike in an ETF is a sign that an institution(s) made a big bet about its
direction. Based on Friday’s negative price action, we view that volume spike as
distribution, not accumulation.

In addition to RKH, we remain short the Dow Jones Industrial
Average, but via the UltraShort Dow 30 ProShares
(
DXD |
Quote |
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News |
PowerRating) instead of the more
popular DIAMONDS
(
DIA |
Quote |
Chart |
News |
PowerRating). Again, DXD is actually a long position that
is inversely correlated to the price of the Dow, and at a 2 to 1 ratio. If the
Dow drops 1%, DXD will move approximately 2% higher. The new ProShares ETFs are
really a great way to participate on the short side of the stock market in an
IRA or other qualified retirement account which cannot be margined for short
selling.

Finally, the Retail Index ($RLX) tested support of its 50-day
MA several times last week, but it should not require much more selling pressure
to cause the index to break below it:

If the $RLX index breaks down, we will probably sell short one
of the Retail ETFs and alert our subscribers via intraday e-mail alert. The
Retail ETFs we are stalking for potential short sale are: IYC
(
IYC |
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PowerRating), RTH
(
RTH |
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Chart |
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PowerRating),
PMR
(
PMR |
Quote |
Chart |
News |
PowerRating), and XRT
(
XRT |
Quote |
Chart |
News |
PowerRating). On the long side, Utilities ($DJU) are one of
the only sectors ignoring the recent weakness in the broad market. The $DJU has
closed at a fresh all-time high in each of the past three sessions, so buying
this sector on a pullback is one of the less risky plays on the long side.

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 .