Commentary:

The broad market began the day with a large opening “gap up,” but momentum faded after the open, causing it to move sideways throughout the remainder of the day. Nevertheless, the major indices closed higher for the sixth straight day, as volume also surged higher. Both the S&P 500 and Nasdaq Composite began the session with 0.8% gains, but both indices drifted modestly lower and closed higher by 0.3% and 0.4% respectively. Still, the S&P 500’s gain caused the index to close at a new 4-year high. The Dow Jones Industrial Average showed relative strength for the second consecutive day and posted a 0.7% gain. It also was the only major index to close near its best level of the session. Small and Mid-Cap stocks took another break. The S&P Mid-Cap Index lost 0.3%, while the Russell 2000 Small-Cap Index shed 0.7%. Yesterday was the second day in a row that large caps outperformed small and mid-caps, which may be indicative of institutional sector rotation back into the “old economy” blue chip stocks.

The Semiconductor Index ($SOX) registered its ninth consecutive day of gains, as it moved another 1.2% higher. The Biotech Index also cruised another 1.8% higher. We continue to hold our long positions in both SMH (Semiconductor HOLDR) and BBH (Biotech HOLDR), which are showing unrealized gains of 6% and 10% respectively. We are, however, now using a tight stop in BBH to protect our 17 point gain. SMH has not yet reached our price targets, but it is doing well so far.

It was encouraging to see that total market volume rose sharply across the board yesterday. Turnover in the NYSE was 17% higher, while volume in the Nasdaq came in 21% higher than the previous day. Yesterday’s higher closing prices combined with higher volume added another “accumulation day” to both the S&P and Nasdaq. It’s bullish that a majority of the “up” days in the S&P and Nasdaq this month have occurred on higher volume. However, yesterday’s rise in volume conversely represented a bearish “distribution day” to the small and mid-cap indices that closed lower. One or two days of distribution in the small and mid-cap indices would not be surprising given their recent gains, but be on the lookout for three or more days of higher volume selling within a two-week period. Overall, the most important element of yesterday’s action was that the S&P’s breakout to a new multi-year high correlated with a surge in volume. Such an important price breakout without a rise in volume would have been a negative sign.

As mentioned above, the S&P 500 closed at a new four-year high yesterday, although it closed below the intraday high of March 7. The daily chart below shows how the index probed above the March 7 high, but closed below it:

It was impressive that the S&P was able to close at a new high after five prior days of gains, but resistance of the March 7 intraday high may give the S&P a good excuse to pause here. A quick breakout to new highs would be more exciting, but it would be much healthier for the market if the S&P trades sideways to lower for a few days before moving to new highs. Either way, keep an eye on the 1,229 level, as it marks resistance of the March 7 intraday high. On the Nasdaq Composite, remember that the 2,178 level is the prior 52-week closing high.

In the July 13 issue of The Wagner Daily, we provided you with a list of all the industry sector ETFs that trade an average daily volume of at least 200,000 shares. We explained that by focusing on specific market sectors rather than limiting yourself to only the broad-based ETFs, your trading opportunities are greatly expanded. The benefit of trading sector ETFs is even greater when the broad market enters into a choppy, range-bound period, as the major indices were throughout the latter half of May and all of June. Knowing which sector ETFs to choose from is a good start, but you obviously need to have a basic strategy for determining which sector ETFs will result in profitable trades. Providing you with all the details would require me to write another book, but I will share one simple, but highly effective method for selecting the strongest sector ETFs to buy or the weakest ones to short.

After establishing which sector ETFs you will keep on your daily watchlist, the next step is to determine which ones are showing the most divergence (relative strength) to the broad market. You can do this by creating a watchlist of your ETFs on your trading software, then by simply sorting the list of sector ETFs by percentage change. We also include the percentage of volume each ETF has traded, relative to its average volume, so that we can spot institutional buying interest that is marked by volume surges. Below is a screenshot (with yesterday’s closing prices) of the layout we use to follow the sector ETFs on TradeStation:

If looking for sector ETFs with bullish trend divergence, pay attention to how the ETF acts on each move the S&P or Nasdaq makes. Sector ETFs with relative strength will usually go sideways to slightly higher when the S&P or Nasdaq drops, but will rocket to new highs on the slightest bounce in the broad market. Conversely, short candidates should barely lift off their lows when the S&P and Nasdaq rallies, and should fall to new lows on any broad market weakness.

Upon scanning the watchlist above, you will quickly spot divergent prices relative to the broad market. Obviously, we want to buy those sector ETFs with the most bullish divergence (relative strength) and/or short those with the most bearish divergence (relative weakness) to the broad market. The sooner you spot the divergent trends, the less risk and higher profit potential for entering a new ETF trade. We have found the best way to catch divergent trends in the early stages is to become disciplined at scanning your watchlist at a regular interval, depending on the type of trader you are. If you are looking for trades with a three to five day time horizon, for example, you would want to scan for sector trend divergence on a daily basis. But traders looking to enter trades with a one to three month time horizon would benefit more from doing scans that show weekly relative strength of the ETFs instead of daily. The frequency with which to look for divergent trends depends on what type of trader you are. Daytraders may prefer to follow the percentage changes on an intraday basis, while longer-term trend traders (such as hedge funds like Morpheus Capital) will look for relative strength on an end-of-day or weekly basis. Regardless of the time horizon you trade, the concept works the same. However, greater trend divergence that results in larger profit potential will obviously come from the longer time periods.

When you spot these divergent trends early enough, you can enter the trade, then simply trail stops to maximize your profits as long as the relative strength remains intact. This is what we are presently doing with our big winning position in BBH. Even though we already have a 17 point gain on the open position in BBH, there has been no reason to sell it yet because it continues to show relative strength to the broad market. However, we did make a decision yesterday to trail a tight stop of one point due to possible exhaustion of the short-term rally. Again, we emphasize that the same techniques of relative strength work on much shorter time frames, even for daytraders, but the divergence is often more clear on a longer-time frame.

One final note regarding the screenshot above is the column labeled “% range.” In addition to simply plotting percentage price changes, we also like to see where each ETF closed the week (or day) relative to its range of that time interval. The closer each ETF closed to the top of its range, the more relative strength it is showing. Conversely, ETFs that close near the bottom of their ranges are showing the most relative weakness. After getting in the habit of scanning all your sector ETFs at a regular interval which you determine, the divergent trends will become apparent. If the same ETFs are showing bullish or bearish divergence every time you do your research, a longer-term trend divergence that occurs from institutional sector rotation is probably taking place. Buying the sector ETFs with bullish trend divergence and shorting those with bearish divergence enables you to ride along on the coat tails of institutions who also realize the benefits of sector trading with ETFs.

Remember that earnings season is upon us, so please be aware of potential earnings reports before entering new positions.

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Today’s Watchlist:

There are no new trade setups for today, as we will focus on managing our three open positions (BBH, SMH, and FXI long).

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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. Net P/L figures are based on the quantity of shares represented
in the MTG
Position Sizing Model.

Closed Positions:

(none)

Open Positions:

BBH long (HALF position, from June 16) –
bought 167.95, new stop 183.75, target (new highs, will trail stop), unrealized points = + 17.45, unrealized P/L = + $872

SMH long (from June 1) –
bought 34.82, stop 34.10, first target 38.85, then 44.90, unrealized points = + 2.07, unrealized P/L = + $621

FXI long (from July 14) –
bought 57.95, stop 55.70, target (new highs, will trail stop), unrealized points = (0.16), unrealized P/L = ($48)

Notes:

We bought FXI on the open yesterday, as it gapped less than 10 cents above our trigger price. We are also now trailing a tight stop on BBH, as it could experience a short-term correction from here.

Edited by Deron Wagner,
MTG Founder and
Head Trader