Commentary:

The broad market closed higher yesterday, as each of the major indices bounced off support of their prior lows of March. Once again, the Nasdaq Composite showed a lot of relative strength to both the S&P 500 and Dow Jones Industrial Average. After beginning the day with an opening gap up, the
Nasdaq trended higher throughout most of the day, while both the S&P and Dow simultaneously traded sideways in a very narrow range. The strength in the Nasdaq prevented the S&P and Dow from selling off, but the weakness in these indices also prevented the Nasdaq from rallying very far. The Nasdaq closed with a gain of 1.9%, but the S&P only closed 0.8% higher. The Dow continued lagging the most and only closed with a 0.3% gain. When the major indices diverge so significantly, it enables you to profit both from shorting stocks and ETFs within the weak indices (Dow and S&P) and from buying in the strong indices (Nasdaq). This is what we did in the MTG Intraday Real-Time Room yesterday, and we profited from both the long and short side of the market. Under current market conditions, it’s a good idea to reduce your overall risk by having positions on both sides of the market.

Unfortunately for the bulls, yesterday’s occurred on significantly lower volume than the previous day. Total volume in the NYSE declined by 19%, while volume in the Nasdaq was 13% lighter than the previous day. Given the recent quantity of days that have consisted of losses on higher volume (“distribution days”), a single day of broad market gains that occurred on lower volume does little to change the current bearish stance of the market. The light volume tells us that yesterday’s gains were more the result of a temporary lull in the selling, rather than an increase in the number of buyers. This is bearish because it only takes another wave of selling to easily undo the gains that were achieved on light volume. Nevertheless, at least the major indices found temporary price support at their prior lows from March, as we anticipated in yesterday’s newsletter.

While daily charts are important for predicting the markets’ price action over the next several days, weekly charts play the important role of showing you the “big picture” of which way the market is trending over the longer term. Because of the long time horizon of weekly charts, you cannot base your day to day trading decisions on weekly charts, but they enable you to determine which side of the market to position yourself overall. If weekly charts of the major indices are all showing primary uptrends, then most of your trades should be on the long side of the market. Conversely, you would want to trade on the short side of the market if the weekly charts are showing a primary downtrend. So, to make sure you are aware of the “big picture,” let’s take a look at the weekly charts of the major indices. First, take a look at the broadest-based of the major indices, which is the S&P 500 Index. We have removed the moving averages so that you can more easily see the trendline:

The thick red trendline on the chart above illustrates the former support of an uptrend line that was intact from March 2003 until March 2004. During that one year period, one of the easiest and most effective trading strategies would have been to simply buy SPY (S&P 500 Index) on every pullback to that trendline, until the primary uptrend was technically broken in March 2004. After breaking support of the uptrend, notice how the S&P rallied in April, but was unable to rally back above the former trendline. This is a clear example of the most basic tenet of technical analysis — prior support becomes the new resistance level once the support is broken. The resistance of this trendline caused the S&P to form a “lower high” on the weekly chart, while the weakness of the past week caused the index to also form a “lower low” because the S&P broke below its prior lows from March 2004. The formation of a “lower high” and subsequent “lower low” on the weekly chart means the S&P 500 Index is now in a primary downtrend. This certainly does not mean the broad market will suddenly collapse and give back all its gains of the prior year, but your odds of profitability will definitely be increased if you focus on the short-side of the market. Only a rally above the April 2004 highs would invalidate the new primary downtrend. Of course, another possible scenario is that the S&P will simply trade sideways for an extended period of time, which would make trading more difficult due to the decreased trading range and volatility.

Below are weekly charts of both the Nasdaq Composite Index and Dow Jones Industrial Average. Notice the similar break of their primary uptrend lines, as well as the subsequent “lower highs” and “lower lows” that were formed.

As the weekly charts illustrate, this is not a time to be aggressive on the long side. While the market bounced yesterday, volume did not confirm any strength to the move, which means the gains can be easily undone. However, even downtrending markets rarely go straight down without bouncing along the way. Therefore, be prepared on both sides of the market and you will reduce your risk. As always, focus on analyzing the market’s volume each day because it will continue to be the only indicator that does not lie. It’s probably relatively safe to be mostly on the short side of the market now UNLESS we begin to see “up” days on higher volume (“accumulation days”).

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Today’s watch list:

There are no new plays for today, but we remain long IEF and short SMH.

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Daily Reality Report:

Below is Morpheus Trading Group’s daily
performance report of closed trades and an update on all open positions from The
Wagner Daily (Intraday Real-Time Room trades are reported separately in The
Wagner Weekly). Net P/L figures are based on the quantity of shares represented
in the MTG Position Sizing Model.

Closed Positions:

(none)

Open Positions:

IEF long (from May 11) –
bought 81.79, stop 81.35, target 83.20, unrealized points = + 0.02, unrealized P/L = + $8

SMH short (from May 11) –
shorted 37.52, stop 37.95, target 36.20, unrealized points = (0.28), unrealized P/L = ($84)

Notes:

Per yesterday’s newsletter, we shorted IEF and also shorted SMH (intraday e-mail alert was sent).

Edited by Deron Wagner,
MTG Founder and
President