The market broke its winning streak

October 2, 2006
Deron Wagner

Stocks concluded the third calendar quarter with little
fanfare last Friday, as the broad market snapped its four-day winning
streak and finished modestly lower. The S&P 500 traded sideways in a tight,
five-point range before closing 0.3% lower. The Dow Jones Industrial Average
also shed 0.3%, while the Nasdaq Composite and S&P Midcap 400 fell 0.5% and 0.6%
respectively. Small cap stocks fared the worst, as the Russell 2000 lost 1.0%.
Although the trading ranges were pretty narrow, each of the major indices
finished at their intraday lows, indicating a bit of profit taking into the
close.

Total
volume in both exchanges declined by 1% on Friday, enabling the S&P and Nasdaq
to dodge a “distribution day.” It was positive that the pullback occurred on
lighter volume, as it indicates institutional investors did not rush for the
exit door while the bulls took a break. For the past several weeks, the market’s
price to volume relationship has been pretty good overall. There have been a few
days of higher volume selling, but that is normal within the context of an
uptrending market. Last week, there were also several days of higher volume
gains, a sign that institutions, and not just retail investors, were behind the
buying activity. Still, the highest volume reading in the NYSE over the past two
weeks was only 1.7 billion shares. Considering the Dow is testing its record
high and the S&P is trading at a five-year high, one might expect more
exciting volume to be coming into the market.

Over the
weekend, we conducted the last in our series of live trading seminars in Los
Angeles, each of which focused on a simple method for sector trading through the
use of ETFs. Given all the speculation of whether or not the new highs in the
S&P and Dow are going to stick, a discussion on the benefits of sector trading
seems to appropriate right now.

At one
time or another, most traders have taken a position in the common broad-based
ETFs such as SPY, QQQQ, or DIA. But only a small percentage of traders pay
attention to the plethora of ETFs that track specific industry sectors such as
Retail, Pharmaceuticals, or Semiconductors. Through years of experience in
trading all different types of ETFs, we have become convinced that the sector
ETFs are consistently a better bet than the broad-based ones. While we
occasionally take positions in the broad-based ETFs, regular subscribers know
that we trade the sector ETFs much more frequently, and with good reason.

The
problem with the broad-based ETFs is that they often tend to be choppy, making
it difficult to participate in long-term trends. If, for example, you invested
in QQQQ on January 1 of this year, you would be showing a gain of exactly 0.6%
(24 cents) as of last Friday’s close. Conversely, there are 15 ETFs that are
showing a year-to-date gain of more than 20%. Did you know that the Telecom
HOLDR (TTH), for example, is up 25% for the year? On the downside, the Internet
HOLDR
(
HHH |
Quote |
Chart |
News |
PowerRating) is showing a year-to-date loss of 26%, a handsome profit if you
were short. These ETFs may not be as exciting as trading QQQQ, but remember that
we are in this business for profits, not thrills. You might be thinking, “That’s
great, Deron, but this is all in hindsight. How can I determine which sector
ETFs are going to make big moves before they happen?” While this was
discussed in detail during our seminar, it is obviously impossible to answer the
question in great detail within the confines of a few paragraphs. Nevertheless,
I will give you one big tip to get you started. It’s called the “percentage
change” overlay chart.

A
standard stock chart shows only the price, along with optional technical
indicators, of a stock or ETF. A “percentage change” chart, however, shows only
the percentage that an equity has gained or lost during a specified period of
time and ignores the actual price. When overlaying more than one ticker symbol
on this type of chart, it becomes an excellent way to quickly determine the
relative strength or weakness of one equity compared to another. Specifically,
we use a broad market index such as the S&P 500 or Nasdaq Composite and overlay
it with the ticker symbol of a sector ETF. If you create a separate chart of
this type with all the major sectors, you will instantly be able to see which
sectors are seeing positive or negative money flow for any given period. Then,
it’s as simple as buying the sectors with relative strength and selling short
those with relative weakness. When using our “percentage change” overlay chart
to compare the performance of the Utilities HOLDR (UTH) with the S&P 500 over
the past two days, here is what you get:

As you
can see, this type of chart enables you to easily spot divergent trends, and
those are the stocks or ETFs you should be positioned in. Regardless of market
conditions at any given time, it is always possible to profit from positions on
both sides of the market because institutional money is constantly
flowing out of one sector and into another. A good example of this is how our
current short positions in the Utilities HOLDR (UTH) and Semiconductor HOLDR (SMH)
both moved 1.1% further into the plus column last Friday, but our long position
in the Biotech HOLDR (BBH) moved higher at the same time. Regardless of the time
horizon for your trades, you can use this type of chart to find relatively
strong or weak sector ETFs before the general public does. If a day
trader, you might use a 5-minute intraday chart interval and see which sectors
are strong or weak thirty minutes after the open. If a swing trader, you may use
60-minute intraday charts that go back a few days. If you hold positions for
several weeks or more, consider using the daily price interval and looking for
divergent trends over the past several weeks. With our hedge fund, we scan the
percentage change charts of all the major sectors on a weekly basis, looking at
how each sector performed relative to the broad market over the past five
sessions. We use line charts instead of candlestick charts because it is easier
to read the line charts when overlayed with two or more symbols.

This, of
course, is only one part of the equation to profitably sector trading ETFs, but
it will get you started nicely. If you learn to spot which sectors are seeing
positive and negative institutional money flow, you can simply ride on the
coattails of the “smart money” through simultaneously buying the ETFs with the
most relative strength and selling short those with the most weakness. After a
while, you won’t really care which way the broad market is trending because you
will always find opportunities on both sides of the market. The financial media
is in a frenzy about whether or not the Dow will break out to a new all-time
high, but we really don’t care either way. There are lots of ETFs that are
trending much better than the Dow and will continue to move in the direction of
their primary trends regardless of whether or not the Dow breaks out. If you
have not already done so, we suggest you
download
our free ETF Roundup guide, as it is a handy reference tool for all
the ETFs, conveniently grouped together by sector and sub-sector.

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 .

The market broke its winning streak

BUY THE FEAR, SELL THE GREED

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