Trading volume: what it tells me

The S&P 500 rallied above resistance
of its two-month sideways range and closed at a new five-year high
last Friday, but lower turnover across the board failed to confirm the breakout.
After beginning the day with an opening gap up, the broad market trended higher
throughout the session and each of the major indices finished near their
intraday highs. Strength in the blue chips enabled the Dow Jones Industrial
Average to zoom 1.2% higher and finish at its highest level since January of
2000. Surprising to some traders and investors, the Dow is now less than 200
points off its all-time high. Both the S&P 500 and S&P Midcap 400 indices
gained 1.0%, while the Nasdaq Composite and small-cap Russell 2000 lagged behind
with gains of 0.8% and 0.9% respectively.

Looking purely at price action, the major indices made
impressive gains, but the one thing suspiciously lacking was higher trading
volume. When an index such as the S&P 500 breaks out of a choppy, sideways range
that has been in place for several months, it normally coincides with a large
surge in trading volume due to traders on the other side of the market covering
their positions, as well as traders buying new positions on the breakout. But
mysteriously, turnover in both exchanges declined last Friday. Total trading
volume in the NYSE fell by 3%, while trading volume in the Nasdaq was 5% lower
than the previous day’s level. In the Nasdaq, it was also the second consecutive
day in which trading volume came in below its 50-day average level. Today’s
issue of popular financial newspaper Investors Business Daily gave this
example of how a negative divergence between price and trading volume can
sometimes lead to surprising results: "Take the action of Jan. 26, 2004. On that
day the Nasdaq powered ahead 1.4%, hitting a three-year high. But trading volume
fell off sharply, retreating 14%. The Big Picture noted the curious gulf between
the market’s price and trading volume action. Stocks fell hard the next day,
then sank into a 6 1/2-month downtrend." It should be noted, of course, that
both the percentage gains and trading volume declines in last Friday’s session
were more moderate, but astute traders will nevertheless be on guard against a
potential failed breakout in the broad market.

With the exception of the Computer Networking
(
NWX |
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Chart |
News |
PowerRating) and
Gold
(
GOX |
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News |
PowerRating) indices, both of which fell about 0.5%, all the major sectors we
follow closed higher last Friday. On a percentage basis, the two biggest gainers
were the Biotechnology Index
(
BTK |
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News |
PowerRating) and the Securities Broker/Dealer Index ($XBD).
However, even though both sectors gained 3.2%, each one was formerly showing a
lot of relative weakness. We therefore view Friday’s gain in those sectors as a
mere technical bounce. As such, we are not looking to enter new long
positions in either sector. On the contrary, we are still stalking the $XBD for
a potential short entry, but only if the index falls back down below last
Friday’s low.

The industry with the third largest percentage gain was the DJ
Utilities Average
(
DJU |
Quote |
Chart |
News |
PowerRating), which broke out above its 200-day moving average
and advanced 2.2%. The strength in Utilities caused our long setup in the
Utilities HOLDR (UTH) to trade through its trigger price as well. The daily
chart of UTH below illustrates the breakout above its 200-day moving average,
which occurred only two days after the index broke resistance of its four-month
downtrend line:

The opening gap up in UTH caused our entry price to be a
little higher than planned, but we are still showing a marked-to-market gain of
more than one point regardless. From here, our upside price target in UTH is
just below the $120 level, which corresponds to resistance of the January 2006
high. We will also trail a stop along the way to protect our profit.

As for our other positions, we made a judgment call to sell
the Regional Bank HOLDR
(
RKH |
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Chart |
News |
PowerRating) into strength last Friday because it did not
seem to be following up its April 27 breakout with the degree of momentum we had
anticipated. Rather than be concerned with whether or not it would break through
resistance of its April 29 high, we informed subscribers via intraday e-mail
alert that we were taking the 1.5 point gain. The S&P Select Energy SPDR
(
XLE |
Quote |
Chart |
News |
PowerRating),
which we sold short on May 3, moved against us a bit last Friday, but closed
only twenty cents above our short entry. The short position in the iShares DJ
Real Estate Index
(
IYR |
Quote |
Chart |
News |
PowerRating) came within three cents of our stop, but we remain
short from our original entry on April 24.

For those who are not aware, the popular iShares family of
ETFs launched ten new funds last Friday that enable traders and investors to
capitalize on more specific sub-sectors of the market. Included in these ten new
exchange traded funds are the iShares Home Construction Index (ITB), the
well-timed iShares Broker-Dealers Index (IAI), and the iShares Aerospace and
Defense Index (ITA). A complete description of the new ETFs can be found by
going to
ishares.com. Separately, we are also pleased to announce that our all-new
Morpheus ETF Roundup, which lists every U.S. exchange traded fund,
grouped by sector and sub-sector in a user-friendly format, will be released
within the coming week. If you’re confused by all the different ETFs out there
and the new ones being released every day, the ETF Roundup is a great way
to stay on top. The first issue will be free to all subscribers, so look for a
download link to be posted here in the coming days.

Overall, we feel it is okay to continue buying the stocks and
ETFs that are showing the most relative strength to the broad market, but just
be alert and on top of your positions in case the situation changes. True, the
S&P 500 did manage to break out of its range, but the lighter trading volume
combined with the relative weakness in the Semiconductor Index keeps us cautious
against a potential failed breakout. Short positions are a bit more risky now,
but we feel that relatively weak sectors such as the Broker-Dealers can be sold
short on any bounces into resistance.

Open ETF positions: