The Wagner Daily | February 8, 2006

Commentary:

The S&P and Nasdaq’s break of their 50-day moving averages took its toll yesterday, as the broad market sold off sharply and turnover increased across the board. The major indices gapped down modestly on the open, trended steadily lower throughout the day, then finished near their intraday lows. Small and mid-cap stocks, which may have begun losing their relative strength, sustained the worst losses. The Russell 2000 Index fell 1.5% and the S&P 400 dropped 1.3%. The S&P 500 lost 0.8%, but the Dow Jones held up relatively well and lost only 0.4%. The Nasdaq Composite shed 0.6%, but the loss would have been much worse if not for the impressive relative strength in the Semiconductor Index ($SOX). Oddly, the $SOX was the only industry sector we follow that closed higher on the day, albeit only by 0.1%.

Volume finally picked up yesterday, indicating a return of institutional activity on the sell side. Total volume in the NYSE jumped 18%, while volume in the Nasdaq increased 21% above the previous day’s level. The substantial losses on firmly higher volume made yesterday a clearly defined “distribution day.” Unfortunately for the bulls, it marked the fifth “distribution day” in the NYSE within the past four weeks and fourth in the Nasdaq. While one to three days of institutional selling is normal within the context of bull markets, stocks typically have a very difficult time recovering from the overhead supply of four or more “distribution days” within a four-week period. If the technical damage on the charts is not enough reason for bulls to pull in the reins, the high number of “distribution days” flashes a clear red flag.

Historically, most bull markets come to an end, or at least sustain a sharp correction, in one of two ways. The first is when the number of “distribution days” increases to more than two or three within a month (as discussed above). Second is when former market leaders begin to lose their strength and break support. As you probably noticed, recent market action has seen both of these scenarios occur. Former market leading stocks such as GOOG, AAPL, and NTRI have all lost their relative strength and have failed to recover from the break of their 50-day moving averages. Worse is that we have begun to see a complete lack of leadership within any industry sector.

Since the new year began, two of the strongest sectors have been Gold Mining ($GOX) and Oil Service ($OSX), but both sustained major losses yesterday. The $GOX collapsed 7.6%, causing the index to break support of an uptrend line that had been in place since mid-December. Similarly, the $OSX plummeted 6.1% yesterday and broke support of the neckline on the bearish “head and shoulders” pattern we have been discussing over the past two days. Considering we have been short OIH (Oil Service HOLDR) since February 3, we were obviously pleased with the ETF’s one-day decline of nearly 9 points! The daily chart of OIH below illustrates the break of the neckline at the $146 level, as predicted in yesterday’s Wagner Daily. Also, note the recent days of higher volume selling (aka “distribution”):

Despite yesterday’s huge loss, we expect further downside in OIH because of the specific chart pattern. When a stock or ETF breaks the neckline of a “head and shoulders” pattern, its predicted drop is typically equal to the distance from the top of the head down to the neckline. Looking at the chart above, you can see this equates to a range of 11 points, or 7%. Therefore, a downside target on the OIH short would technically be 7% below the neckline, or a price in the $136 area. We have found the “head and shoulders” pattern will follow through with this predicted drop about 60% of the time. However, note that support of the 50-day moving average is presently just over $138, so that level may be a safer place to take profit or at least tighten your stop.

If we were forced to pick one industry to buy, Semiconductors are probably showing the most relative strength right now (outside of the Chinese stocks and ETFs). However, we do not advise fighting the overall market trend. It makes no sense to go long the only sector that is holding up when you can easily short just about every other sector. Trading with a “top-down” mentality is usually the safest and most profitable way of positioning yourself. This means that one must first be sure to trade in the general direction of the market before determining which individual sector and stocks to trade.

The S&P 500 broke support of its prior low from January yesterday, causing the index to form a “lower low” on its daily chart. This means the S&P has now formed both a “lower high” and “lower low” on its daily chart, technically forming a new intermediate-term downtrend. The daily chart of SPY (S&P 500 Index) illustrates this:

The break of the 50-day MA created a lot of overhead supply and yesterday’s break of the prior low created more. Therefore, we expect the S&P to have a very difficult time putting in any kind of significant rally attempt in the short-term. Just as water flowing down a hill always follows the path of least resistance, so does the stock market. Even if the bears take a rest, it would require a lot of demand to absorb all the supply that has been created over the past two weeks. Needless to say, our overall bias on the broad market remains on the short side. In addition to OIH, we remain short SPY, currently showing a 1-point gain from our entry point, and XLU, which is showing a small profit on the short side.

Today’s Watchlist:

There are no new setups for today, as the model account is near its maximum equity exposure. Instead, we will focus on managing the three open positions closely.

Daily Performance 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):

stop 152.20

unrealized P/L = + $520

SPY short (400 shares from Feb. 3 entry) –
shorted 126.58, stop 127.55, target 122.60, unrealized points = + 1.10, unrealized P/L = + $440

XLU short (700 shares from Feb. 2 entry) –
shorted 32.03, stop 32.59, target 30.15, unrealized points = + 0.37, unrealized P/L = + $259

Closed positions (since last report):

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

$86,844

Notes:

Click
here for glossary and explanation of terms used in The Wagner Daily

Click here to view MTG’s past performance results (updated monthly).

Edited by Deron Wagner,
MTG Founder and
Head Trader