Why you should watch fixed income ETFs

Continued weakness in the
Semiconductor Index
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the losses in the S&P and Dow were more subdued. The Nasdaq Composite
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lost 0.8%, causing the index to close back below its 200-day moving average
after trading above it for the past week. The small-cap Russell 2000 showed
relative weakness by falling 1.2%, while the S&P Midcap 400 gave up 0.7%. The
S&P 500
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only 0.3% and 0.2% respectively. A modest wave of buying one hour before the
close helped the major indices to finish near the middle of their intraday
ranges. For the week, both the S&P and Dow lost 0.4%. The Nasdaq declined 0.7%.

Turnover declined across the board, enabling the markets to
dodge a “distribution day.” Total volume in the NYSE was 13% lower than the
previous day’s level, as volume in the Nasdaq declined by 17%. Even though the
Nasdaq lost 1.5% over the past two sessions, it has done so on lighter volume
both days. This is positive because it indicates that institutions have not yet
been rushing for the exit doors as the market enters its corrective phase.
Nevertheless, the S&P has already had four days of higher volume losses within
the past twelve sessions. Market internals were negative in both exchanges, but
much worse in the Nasdaq. In the NYSE, declining volume exceeded advancing
volume by a margin of less than 2 to 1, but the Nasdaq was negative by a ratio
of more than 3 to 1.

One group of exchange traded funds that made a stealth move to
the upside last week was the iShares family of fixed-income (bond) ETFs. As the
yield on government T-bonds dropped last week, the price of the corresponding
fixed-income ETFs rose higher. The iShares 20+ year Treasury Bond Fund
(
TLT |
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not only zoomed 2.5% higher last week, but it also broke out above resistance of
its primary downtrend line from the high of June 2005. This is illustrated on
the weekly chart of TLT below:

Because TLT is a bit extended above its downtrend line, there
is not a very positive risk/reward ratio for buying at its current level.
However, remember that a prior resistance level always becomes the new support
level after the resistance is broken. Therefore, any retracement down to the
breakout level of the prior downtrend line would present a low risk entry point
on the long side. We would even consider taking a partial position on a 38.2%
Fibonacci retracement of last week’s move.

If you’re not familiar with the fixed-income ETFs, you may be
interested to know that each one, just like an actual bond, pays dividends to
your brokerage account on a monthly basis. Presently, the distribution yield of
TLT is 4.63%. When combined with the actual price appreciation that TLT has been
showing lately, it may be one of the better ETF positions to own right now. Just
be sure to wait for the proper entry point! Patient, disciplined traders are
consistently rewarded in the long-term. For a list of the other fixed-income
ETFs, download our free

Morpheus ETF Roundup guide.

Looking at the hourly chart of the S&P 500, you will notice
that the index is in the process of forming the right shoulder of a bearish

“head and shoulders” chart pattern. So far, the right shoulder is much lower
than the left shoulder, but it could easily bounce higher before going lower. If
it doesn’t, that’s even better because it tells us that the S&P is very weak. We
have labeled the components of the head and shoulder pattern on the hourly chart
below:

The interesting thing about the S&P right now is that the
“head” of the head and shoulders pattern also corresponds to a failed breakout
to a new 52-week high. The head and shoulders pattern has a higher rate of
accuracy when it forms at the top of an uptrend as opposed to mid-trend or
anywhere else. The key for this pattern to work is that the S&P must break below
its “neckline” at the 1,310 to 1,312 area, presently a pivotal area of
short-term support. If the S&P breaks below this level, we should see
significant follow-through to the downside. As a rule of thumb, the downside
price target on a head and shoulders pattern is equal to the distance from the
top of the head down to the neckline. In this case, that equates to an
anticipated move of 18 points below the neckline. If you subtract 18 points from
the 1,310 support level of the neckline, you get a downside price target of
around 1,292. Curiously, the 1,292 area also correlates to support of the prior
low from September 7 – 11. The 50-day MA will provide support in that vicinity
as well. Isn’t it odd how often technical levels of support and resistance
converge with one another?

Obviously, a rally above the top of the head (over 1,329)
would completely invalidate the head and shoulders pattern and require us to
stop out of any short position in the S&P 500. A rally above the top of the head
could generate a lot of upside momentum, so be sure to keep a tight stop over
that level in case the pattern fails to follow through. Rather than being short
the S&P 500 SPDR
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ProShares
(
SDS |
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low volatility broad-based ETFs. Buying SDS instead of selling short SPY also
enables one to take a bearish position in a non-marginable account such as an
IRA or other retirement account.

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 .