Watch the Semis, here’s why

Volume picked up yesterday, causing both the S&P 500 and Nasdaq Composite to
register bearish “distribution days.” Total volume in the Nasdaq surged 29%
higher, while volume in the NYSE was 16% higher than the previous day’s level.
However, despite the increase, note that turnover in both exchanges still came
in below average levels. It has been eight days since volume in either the NYSE
or Nasdaq exceeded its 50-day average level. Not surprisingly, market internals
were firmly negative. In the Nasdaq, declining volume exceeded advancing volume
by a margin of more than 7 to 1. The NYSE ratio was negative by 4 to 1.

One sector that weighed heavily on the broad market yesterday was the
Semiconductor Index
(
SOX |
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PowerRating), which plummeted 3.8% and closed at its lowest
level since November 1, 2005. Semiconductor stocks comprise a very large
percentage of the Nasdaq, so the Nasdaq typically follows the direction of the
SOX. If this is the case, one could infer that the Nasdaq will soon break down
below its “swing low” of June 14 as well:

Although the SOX itself broke down below its prior low yesterday, none of the
semiconductor ETFs did so — yet. The most popular of these ETFs, the
Semiconductor HOLDR
(
SMH |
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PowerRating), finished 1% above its June 13 low. The other
three semiconductor ETFs are: iShares
(
IGW |
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PowerRating), PowerShares
(
PSI |
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PowerRating), and
StreetTRACKS
(
XSD |
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PowerRating). All three are just above their prior lows, but could
easily gather a lot of downside momentum with any further weakness in the SOX.
If you want to gauge the overall health of the market, you need to look no
further than the terrible performance of the SOX.

Over the past several days, we have been on alert for a swift move in either
direction and a volatility expansion in the broad market. That move began
yesterday. With textbook precision, resistance of the downtrend lines in both
the Nasdaq Composite and S&P 500 triggered the broad-based selloff. The downward
move also caused both indices to close below their respective lows of June 21.
As such, odds are now pretty good that the major indices will soon re-test their
“swing lows” of June 14. Looking at the daily charts below, notice how the
seven-week downtrend lines perfectly acted as resistance that triggered the
selloff. The horizontal dashed line (in blue) marks the break of the June 21
low. This is significant because June 21 was a reversal attempt that has now
technically failed:

If there were no major news events forthcoming, we would feel confident about
getting more aggressive on the short side, but there is one big caveat — the
Feds will announce their decision on interest rates this Thursday afternoon. As
you probably already know, FOMC meetings typically result in unpredictable
market volatility. Therefore, we are going to continue playing it conservatively
until the Federal Reserve Board enlightens us with their decision and
forward-looking commentary. Obviously, overall odds now favor the short side of
the market, and it is fine to have a few open short positions. But just be
prepared to act quickly if the market reacts favorably to the interest rate
announcement on Thursday. Both indices are still in close proximity to their
downtrend lines and the June 21 undercuts were only by a marginal amount, so
don’t be complacent on the short side.

Long TTH and GLD, short IYT (regular subscribers to

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