The Wagner Daily | August 25, 2005

Commentary:

After beginning the day with an opening gap down, the major indices promptly reversed and rallied throughout the morning, but afternoon sell programs caused the broad market to fall sharply in the afternoon. The Nasdaq Composite had rallied to a 0.9% gain at mid-day, but major relative weakness in both the S&P and Dow acted as an anchor and dragged the Nasdaq down to a closing loss of 0.4%. The Dow Jones Industrial Average, which significantly lagged behind the Nasdaq during the morning rally, paced the broad market’s losses in the afternoon, eventually closing with a 0.8% loss. The S&P 500 Index similarly fell 0.7%. The S&P 400 Mid-Cap Index and the Russell 2000 Small-Cap Index, which showed mid-day gains of 0.9% and 1.1% respectively, both plummeted in the afternoon and closed 0.1% lower.

Yesterday’s erratic and wild volatility was also accompanied by a large volume spike in both exchanges. Total volume in the Nasdaq rocketed 28% higher, while volume in the NYSE surged 15% higher than the previous day’s level. The increase in volume across the board means that yesterday registered as a bearish “distribution day” for both the S&P 500 and Nasdaq Composite. In the Nasdaq, it was the fourth such day of institutional selling within the past four weeks, while the S&P has had three “distribution days” within the same period. A healthy market can usually absorb one or two days of higher volume losses, but uptrends can easily reverse when the broad market has sustained four or more “distribution days” within a one month period. As we have seen over the past couple of days, market internals were strong in the morning, but became negative in the late afternoon. The difference this time, however, is that volume in both exchanges exceeded 50-day average levels. The sharp rise in volume confirms the validity of yesterday’s sell-off.

If you actively traded yesterday’s session, it surely kept you on your toes! If you came into the day mostly short, you probably were forced to cover many of your positions by mid-day, only to have them collapse in the afternoon. Worse is that perhaps you covered your short positions and went long, reasonably thinking the Nasdaq was finally bouncing off its 50-day MA, only to find yourself taking losses on both sides of the market. If so, don’t feel too bad about it. Without a doubt, yesterday was equally tricky for both the bulls and bears! Hopefully you heeded our recent advice and were positioned mostly in cash, or at the very least, avoided trading the broad-based ETFs such as SPY or QQQQ.

As for the Wagner Daily plays, the morning rally caused the RTH short to hit its trailing stop, but we locked in a gain of nearly 2.5 points. The remaining shares of UTH short also stopped out in the morning, but our profit from the first half of the position limited our loss on the trade to less than 30 cents. We also bought a small position of BBH when the setup triggered at mid-day, but it reversed with the Nasdaq and is already near our stop. Between the solid gain in RTH, small loss in UTH, and the (unrealized) loss in BBH, yesterday was basically a scratch, but it surely would have been worse if we were attempting to trade the broad-based ETFs as well. Novice traders may sometimes get bored with our lack of new trade entries in challenging market conditions, but part of being a professional trader and hedge fund manager is knowing when to focus more on managing existing positions than aggressively entering new ones. Being positioned mostly in cash the past few days has undoubtedly saved us money!

Looking forward, the good news is that yesterday’s action caused both the S&P and Dow to break out of their narrow and choppy ranges that have plagued the market for the past week. Most notable is that the Dow cracked below its range of the past several weeks and closed firmly below both its 50 and 200-day moving averages. Although it closed the previous day below its 50 and 200-day MAs as well, it was not until yesterday that the index fell below support of its trading range. Because it is trading below its key moving averages, the Dow does not have any major price support until it drops to its prior lows near the 10,270 area. We have circled the next key area of price support on the daily chart of the Dow below:

Prior support becomes the new resistance level after the support is broken, which means that the 50 and 200-day moving averages will now act as resistance on any rally attempt in the Dow. Shorting DIA (Dow Jones) over the next few days is a safe bet if you keep your stop just above the 50 and 200-day MAs. The index may attempt to bounce a bit today, but it should not exceed yesterday’s high.

Like the Dow, the S&P 500 also closed firmly below support of its 50-day MA yesterday, but it also broke support of its primary uptrend from the May low. As such, we are likely to see further downside on the S&P as well. A short-term price target on the S&P would be the 1,190 to 1,195 area, which is where the prior lows from late June and early July converge with the 200-day MA. Conversely, the 50-day MA, along with the lows of the past week, should act as overhead resistance from the 1,215 to 1,220 area. A bounce into that price range would create a low-risk entry point to sell short SPY (between 121.80 to 122.15). The chart of the S&P 500 below illustrates yesterday’s break of the primary uptrend line, as well as the next key area of support:

The Nasdaq Composite formed a bearish “inverted hammer” candlestick yesterday, which was caused by the big rally in the morning and even larger drop in the afternoon. This candlestick pattern usually leads to lower prices in the short-term, which is even more likely considering that the Nasdaq closed below its 50-day MA for the first time since May 13. The Nasdaq tested support of its 50-day MA in the two prior days, but yesterday was the first time it actually closed below it in three and a half months. However, despite yesterday’s weakness, the Nasdaq continues to show relative strength to both the S&P and Dow. As such, we would avoid shorting QQQQ or ONEQ because they would be among the first of the broad-based ETFs to recover if buyers return to the market. Next support on the Nasdaq Composite is the prior highs of June, near the 2,100 area:

Finally, we want to bring your attention to the Broker-Dealer industry sector ($XBD), which we feel presents a good shorting opportunity. From the beginning of May through the middle of July, the $XBD index rallied steadily higher, then began to consolidate in a sideways range. While a consolidation near the highs is bullish and usually leads to new highs, a break below support of that consolidation is equally bearish because it traps the longs who were anticipating new highs. Furthermore, consolidations near the highs have a high rate of failure during bearish market reversals, so they often present low-risk short entry points after the consolidation has begun to fail. Yesterday’s drop in the $XBD put the index below its prior low from August 18, which means the sector may be poised for lower prices. There is still support of the 50-day MA just below, but we wanted to give you an early heads-up to keep an eye on the broker-dealer stocks for potential shorts. There is not an ETF that directly tracks the broker-dealer index, but you can make your own “synthetic ETF” by trading a small basket of stocks within the sector. Some of the big ones are: MER, GS, LEH, and BSC (which is listed as a short setup in today’s Stalk Sheet). Interestingly, we also noticed that yesterday afternoon’s selloff in the $XBD index coincided with the Dow dropping sharply below its 200-day MA. Notice how the $XBD plummeted during the final hour of trading:

Because the 200-day moving average is generally viewed as a gauge of the general public’s long-term sentiment, many traders and investors fear that profits in the broker-dealer stocks will be directly harmed by the resumption of the bear market that began in 2000. Of course, we never base our trade ideas strictly on fundamentals, but it is an interesting theory to ponder nevertheless.

Overall, our bias has now shifted from neutral to negative for intermediate-term plays, particularly in the Dow-related sectors such as Financial, Construction, and even Energy. We are also watching MDY (mid-caps) for a potential short entry (subscribers can see details on the watchlist below). You may also want to keep an eye on Biotechs to see how they hold up, as that sector has been known to ignore broad market downtrends in the past. Techs also still holding up okay. Yesterday’s selloff may not have been what you wanted to see if you’re a bull, but the positive is that the market may now break out of the choppy and erratic range of the past week. Any trend, either up or down, is better than a narrow-range, sideways market.

Today’s Watchlist:

MDY – S&P Midcap Index
Short

Trigger = half below 128.10, half below 127.60 (below yesterday’s low and the Aug. 18 low)
Target = 123.20 (June 24 low)
Stop = 129.90 (above yesterday’s high)
Shares = 300

Notes = MDY closed below its 50-day MA yesterday and is now poised to break below its range to new lows. For this setup, we will use a scaled entry, shorting 150 shares below yesterday’s low, then another 150 if it breaks the Aug. 18 low. Depending on who your broker is, you may need to call ahead and request location of MDY shares if you want to initiate a short position.

Daily Reality Report:

Below is an overview of all open positions, as well as a performance report on all positions that were closed only since the previous day’s newsletter. Net P/L figures are based on the $50,000 Wagner Daily model account size. Changes to open positions since the previous report are listed in red text below:

Open positions (coming into today):

10 cents below low of first 20 minutes

unrealized P/L = ($378)

Closed positions (since last report):

net P/L = + $494

UTH short (150 shares from Aug. 10) –
shorted 113.13, covered 114.60, points = (1.47), unrealized P/L = ($224)

Current equity exposure ($100,000 max. buying power):

$37,792

Notes:

MTG Opening Gap Rules

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Edited by Deron Wagner,
MTG Founder and
Head Trader