The SOX: rolling over

The major indices kicked off the
third quarter on a negative note, as stocks closed lower across the
board. After beginning the day relatively flat, the broad market rallied into
positive territory in the late morning, but an early afternoon selloff forced
stocks below their morning lows. The Nasdaq Composite
(
COMP |
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S&P 500 [SPXSPX] 0.3%, and the Dow Jones Industrial Average
(
DJX |
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Dow tried and failed to break out to a new all-time high for the fourth day in a
row. The small-cap Russell 2000 declined 0.9%, while the S&P Midcap 400 lost
0.5%. Like the previous day, each of the major indices finished near their
intraday lows.

Although stocks have posted losses over the past two sessions,
they did so on lighter volume both days. Total volume in the NYSE was 5% lower
than the previous day’s level, while volume in the Nasdaq decreased by 2%.
Turnover picked up during the early afternoon selloff, increasing the morning’s
overly light levels, but the increase was still not enough to register a bearish
“distribution day.” So far, the recent correction has been rather orderly and
has not shown any signs of institutional investors dumping shares. Market
internals were negative, but not by an extremely wide margin. In the NYSE,
declining volume exceeded advancing volume by just over 3 to 2. The Nasdaq was
ratio by a little more than 5 to 2.

We often discuss the power of the 200-day moving average as a
major area of support or resistance for an index, stock, or ETF, and the iShares
DJ Transportation Average
(
IYT |
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formed a double top at its 52-week high at the beginning of July, then reversed
to the downside with a 17% loss in the seven consecutive “down” weeks that
followed. Since forming its low on August 11, IYT has been trading in a sideways
range, with its consolidation having tightened up over the past few weeks. As
the daily chart below illustrates, IYT has tried to break out above its 200-day
moving average about ten times since forming its August low, but the pivotal
area of resistance has acted like a brick wall each time:

If IYT manages to firmly close above its 200-day MA, it will
likely see at least a short-term, momentum driven pop to the upside. This is
what happened to the Biotech HOLDR
(
BBH |
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PowerRating) when it busted out above its 200-MA
four days ago. However, it is important to realize that each successive failed
attempt to break out above its 200-day MA weakens the resolve of the bulls. If
the buyers eventually throw in the towel, it will attract the interest of the
short sellers who have been focused on that 200-MA. Such a chain of events would
lead to a selloff that would force IYT down to at least its prior low. We think
a break of the four-day low can be sold short, especially if higher than average
volume confirms the selloff. If you initiate such a play, be sure to keep a firm
stop above the 200-day moving average to protect against a failed breakdown.
With a stop just above the 200-MA, you would also be looking at a very positive
risk/reward ratio on the setup.

The Semiconductor Index
(
SOX |
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PowerRating), a heavily weighted
component of the Nasdaq, appears to be in the process of rolling over. On
September 22, the index closed below support of its two-month uptrend line, but
snapped back above it the following day. On September 27, it attempted to test
its prior highs from the middle of September, but looming overhead resistance of
the 200-day MA caused a bit of trepidation on the part of buyers. As such, the
$SOX appears to have set a “lower high” over the past few days and has been
showing relative weakness to the broad market. The Semiconductor HOLDR
(
SMH |
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PowerRating),
which is poised to fall below its 20-day MA, has a very similar chart pattern:

Because we remain short the Semiconductor HOLDR (SMH), we
continue to believe the $SOX will break back down below its primary uptrend line
and at least test support of its 50-day moving average. If it does, this is a
major negative for the broad market because the $SOX typically leads the Nasdaq,
which often leads the S&P and Dow. Negative earnings guidance from Semiconductor
stock Marvell Technology after yesterday’s close will likely weigh on the $SOX
index today as well.

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 .