Why the Nasdaq is key today

The selloff that began on May 11
gained momentum Wednesday, as the major indices suffered another
round of severe losses on higher volume. The broad market began the day with an
opening gap down, but failed to recover from it, triggering another slide that
resulted in a steady intraday downtrend. Contrary to recent action, the Dow
Jones Industrial Average posted the worst loss of the major indices, closing
1.9% lower. The S&P 500 similarly lost 1.7%, while the Nasdaq Composite dropped
1.5%. Again, there was nowhere for the bulls to hide, as small and mid-cap
stocks fared no better. The Russell 2000 Index gave up 1.6% and the S&P Midcap
Index lost 1.8%. Each of the major indices opened at their intraday highs and
closed at their lows, continuing the refreshing change from a choppy, erratic
market to a steadily trending market that is ideal for short-term “trend
traders.”

Turnover surged higher across the board yesterday, tacking on
another session of institutional selling to the count. Total volume in the NYSE
increased by 23%, while volume in the Nasdaq was 15% higher than the previous
day’s level. All but one day of the broad market’s losses since the selloff
began has been on higher volume. Even when stocks eventually bounce, so much
overhead supply has been created by the numerous “distribution days” that the
market is unlikely to retrace much of its losses, at least in the short-term.
Worse than yesterday’s high volume was the extremely negative market internals.
In the NYSE, declining volume trounced advancing volume by a margin of more than
9 to 1! The ratio in the Nasdaq was negative by 5 to 1. On a typical day of
losses in a choppy or uptrending market, it is common to see this ratio by
negative by 2 to 1 or even up to 4 to 1, but advancing volume in the NYSE was
nearly non-existent yesterday. You need to go all the way back to the year 2000,
when stocks began collapsing from the amazing bull run of the late ’90s to see
such extreme ratios. We won’t speculate as to whether this is the start of an
equally nasty bear market, but suffice it to say that, unless you are a
traditional “buy and pray” investor, we definitely think it is now wrong to be
long for anything more than a quick bounce off a key support level.

On a technical level, several key events took place in the
broad market yesterday. The Nasdaq, which tried to hold at support of its
200-day moving average in the previous two sessions, closed firmly below it.
This is significant because most institutional traders view the 200-day moving
average as a long-term “line in the sand” that determines whether or not they
are net buyers or sellers of stock. The 50-day moving average has a similar
significance, but is usually associated as a sentiment indicator for the
intermediate-term. Remember that a prior support level becomes the new
resistance level after the support is broken, so expect the Nasdaq to have
difficulty recovering back above its 200-day MA in the near-term:

Of greater concern is that the Nasdaq also closed below
support of its long-term monthly uptrend line. Since the market bottomed out in
October 2002, the Nasdaq has been steadily moving higher, having its most recent
anchor of its uptrend line with the low of October 2005. However, the Nasdaq is
now sitting squarely below that uptrend line, confirming the bearishness of its
fall below the 200-day moving average. As the dashed horizontal line on the
weekly chart below illustrates, the Nasdaq is now only six points above its 2006
low. A break below that level will confirm the break of the monthly uptrend
line:

If you rarely study the longer-term monthly charts of the
major indices, now is probably a good time to do so. Like the Nasdaq, the S&P
500 also closed yesterday below support of its multi-year uptrend line, but only
by a small margin. As of yesterday’s close, the S&P is now only 2% above its
2006 low, so watch the 1,245 level as a major area of support that needs to
hold. If that level is broken, it could lead to a pretty bearish remainder of
the year:

On the ETF front, low-risk long setups are now few and far
between. There are a few sectors such as Semiconductors in which the selling is
probably overdone in the short-term, but the overly bearish sentiment in the
market right now means that you need to be quick and disciplined if attempting
to play any bounces on the long side. Instead, you now have a much better
risk/reward of waiting patiently for the broad market and weak sectors to
bounce, then selling them short when they begin to roll over again. We have our
eyes on a few such ETFs and will keep you abreast of setups we like when they
present ideal entry points in the coming weeks.

Although the recent market environment is not ideal for
long-term investments, it is a welcome reprieve from the months of chop and lack
of follow-through that has made it difficult for short-term “trend traders” such
as ourselves to profit. Case in point is that our short position in the S&P
Select Energy SPDR (XLE) actually hit its price target yesterday! Despite having
provided quality setups to subscribers for months, it has been a while since a
trade in either direction trended all the way to our original price
target. We covered the remaining shares of the XLE short position for a gain of
nearly 5 points (7.8%). Our only open position is now the iShares Russell 2000 (IWM),
which we sold short on May 16. We have also removed the long setup in the
Biotech HOLDR (BBH) from our watchlist.