What To Watch For In The SMHs And SPYs

Relative strength in the
Semiconductor Index ($SOX), which rocketed 2.5% higher yesterday,
sparked a higher volume rally that led the Nasdaq Composite to a 1.0% gain and a
fresh four-year high. Both the S&P 500 and Dow Jones Industrial Average followed
suit, closing higher by 0.7% and 0.6% respectively. Utilities ($DJU), which
zoomed 2.5% higher, and Oil Service ($OSX), which gained 2.2%, were among the
strongest sectors in the S&P. The S&P 400 Mid-Cap Index and the Russell 2000
Small-Cap Index also kept pace with the major indices, as both indices once
again closed at new record highs. Each of the indices closed near their intraday
highs, which bodes well for potential upside follow-through in today’s morning
session.

Perhaps the biggest positive of yesterday’s market action is
that volume in both exchanges came in higher than the previous day and
above average levels. Total volume in the NYSE surged 15% higher, while turnover
in the Nasdaq increased by 18%. Internals were equally bullish, as advancing
volume exceeded declining volume by a ratio of 2.5 to 1 in the Nasdaq and 2.1 to
1 in the NYSE. Most important of the internals is that volume in both the NYSE
and Nasdaq exceeded their 50-day average levels. This was a welcome reprieve
from the light volume in the Nasdaq throughout the past week.

The fact that yesterday’s gains were broad-based throughout
many sectors, combined with higher overall volume levels, tells us that
institutions such as mutual funds were behind yesterday’s rally. The reason we
pay so much attention to analyzing broad market volume levels is that
institutional trading activity accounts for approximately 80% of the market’s
volume on a daily basis. Rallies cannot be sustained for long periods of time
without institutional backing, and a daily analysis of overall volume levels
tells us whether or not institutions are at work behind the scenes.

One of the reasons we discuss the $SOX index so frequently is
because the semiconductor stocks are so heavily weighted within the Nasdaq. As
such, the $SOX usually leads the Nasdaq, which in turn sets the pace of the
other major indices on most days. Rarely will the Nasdaq rally sharply without
the $SOX leading the way. As anticipated and discussed in yesterday’s Wagner
Daily, the Semiconductor HOLDR (SMH) broke out above its bullish
consolidation of the past two weeks and set a new 52-week high yesterday. This,
of course, is bullish for the overall broad market. The daily chart below shows
the breakout that resulted in a 2.1% gain in SMH:

Remember that prior resistance levels become the new support
levels after the resistance is broken. Therefore, the prior resistance of SMH
(the upper channel marked by the red line above) should now act as support on
any price retracement in SMH. Because of this, we are now raising our stop on
SMH to just below yesterday’s low, as a violation of that low would be negative.
We plan to sell half of the SMH long position into strength as it nears our
first price target. We have also tightened the stop in FXI to protect our 5.8
point gain (see position recap below if you are a subscriber).

Although the Nasdaq Composite broke out to a new high
yesterday, both the S&P 500 and Dow Jones Industrial Average remain within the
channels of their sideways trading ranges. The S&P 500 technically closed half a
point above last week’s closing high, but is still below the intraday high of
last week. The intraday high of last week is 1,245.15 in the S&P (124.64 for
SPY). Needless to say, those levels should be watched closely as pivotal areas
of resistance in the S&P and SPY going into today’s session. The resistance is
marked by the red horizontal line on the chart of the S&P 500 below. First
support in the S&P is marked by the blue uptrend line, followed by the 20-day
moving average below that:

In the laggard Dow Jones, resistance is found in the range of
10,700 to 10,717 (last week’s high). Divide those numbers by 100 to know the
corresponding resistance in DIA.

For the best odds of success in the short-term, stick to ETFs
and stocks that are Nasdaq-related, such as SMH, BBH, or QQQQ. The “old economy”
sector and broad-based ETFs such as PPH, RTH, or DIA should be restricted to
ultra short-term momentum trading. The technical patterns of most of them are
not as clear as the breakouts in SMH and BBH.

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.