The Wagner Daily | May 23, 2006

Commentary:

Just as quickly as the Semiconductor Index ($SOX) popped 3% last Friday, it dropped 4% yesterday, dragging the Nasdaq and the other indices lower as well. Both the Nasdaq Composite and small-cap Russell 2000 Index fell 1% yesterday, giving back all of the previous day’s gains and then some. The S&P Midcap 400 continued to show relative weakness with a 0.8% decline, while the S&P 500 and Dow Jones Industrials lost 0.4% and 0.2% respectively. Despite the losses, many stocks recovered off their lows in the afternoon, but selling pressure in the final thirty minutes caused the major indices to finish in the middle of their intraday ranges.

Total volume in the NYSE declined by 8% yesterday, while volume in the Nasdaq was 10% lighter than the previous day’s level. Given that most of the down days in the market over the past two weeks have been on higher volume, it was a positive that turnover declined yesterday. However, the previous session’s “accumulation day” has now been invalidated because the broad market wiped out all of its prior day’s gains. Even though volume declined in both exchanges, bearish market internals confirmed yesterday’s losses. In both exchanges, declining volume exceeded advancing volume by a margin of 3.3 to 1.

If you have been watching the action in the semiconductor sector over the past two days, you may have acquired a good feeling for just how weak the market really is right now. After failing to break out above resistance on May 5, the $SOX fell victim to a nine-day losing streak before finding any buying interest. Finally, the index rallied more than 3% on May 19, recovering its losses of the three prior days in the process. When such a swift retracement takes place, an index usually will at least linger in that range for a few days, or even attempt to move a bit higher, before resuming the direction of its trend. But such was not the case for the $SOX. Instead, sellers aggressively attacked the semiconductor stocks when the market opened yesterday, causing the $SOX to surrender its prior day’s gain within the first hour of trading. By day’s end, the $SOX had closed at a new six-month low. Looking at the daily chart below, notice how the $SOX was so weak that it completely ignored support of its 200-day moving average on May 12:

As you might have guessed, such action as described above indicates a market that is in a very strong trend. Unfortunately, strong trends often present a bittersweet dilemma. The positive of a strong market trend (either up or down) is that quality trade setups have a much better change of succeeding at generating solid profits. The negative, however, is that strong trends often do not provide us with low-risk entry points that come from waiting for a price retracement. In the case of strong downtrends, they often collapse so fast that you can easily miss the boat if you failed to short the initial (and riskier) break of support. Conversely, strong uptrends often surge higher without providing a significant pullback for a lower risk entry point.

When trends are strong and price retracements are minimal and/or very short-lived, there is a basic strategy that will still provide you with the opportunity for profits, but without the risk that comes from being a “late to the party Charlie” and chasing the big moves that already occurred. The first thing you must remember is that market corrections always happen in one of two ways: a correction by price or a correction by time.

A correction by price, more commonly known as a “pullback” or “retracement,” occurs when a stock or index reverses against the direction of its primary trend until it hits some sort of resistance or support level, depending on whether in a downtrend or uptrend. In a steadily downtrending market, such as the one we are in now, retracements up to resistance of both the 20 and 40-period moving averages on the hourly charts often provide ideal entry points for new short positions. A very weak stock or ETF will often retrace only up to the 20-MA and then resume the downtrend, while an ETF with a bit more strength might make it all the way up to the slower 40-MA. One recent example of such a correction by price is the iShares Russell 2000 Index (IWM), which we sold short when it rallied into resistance of its 20-MA on the hourly chart on May 16 and covered for nearly a 4% gain three days later:

Looking at the hourly chart above, notice how the first time IWM ran into its 20-MA since the selloff began was on May 16, the same day we sold it short. Since then, notice how that 20-MA has perfectly acted as resistance that ensured a continuation of the downtrend. Each bounce into the 20-MA that you see circled above is a good example of a short-term correction by price.

When a stock or index is showing absolutely no signs of buying interest, it will still correct from a large selloff, but it will often have a correction by time instead. This simply means that, rather than retracing a portion of the trend, it will trade sideways, near the bottom (or top) of the range. A good example of this can be found on the daily chart of the Oil Service HOLDR (OIH):

On the circled portion of the chart, notice how OIH came down to its 50-day moving average, but failed to bounce off that support level. Instead, it “corrected by time” for two short days and then broke down to new lows. When this occurs, you can enter a new short position on a break out of the range. In this case, you could have shorted OIH when it fell below the lows of both May 15 and 16. When the lows also converge with a pivotal moving average such as the 50-MA, it further increases the odds of a successful trade. We didn’t short OIH when this occurred, but we did realize a very substantial profit from a short position in the S&P Select Energy SPDR (XLE), which had a similar chart pattern.

Having a basic understanding of the ways in which markets correct will prevent you from being “late to the party” and selling short at the bottom of a selloff or buying at the top of a breakout. In the current environment, you merely need to find the stocks and ETFs that have settled into steady downtrends, then wait patiently for either a “correction by price” into a resistance level or a “correction by time” so that you can short a breakdown to new lows. If the security has so much relative weakness that a “correction by time” is the only correction you get, it is advisable to reduce your position size in order to compensate for the slightly increased risk of not getting the most ideal entry point. At present, we are stalking a handful of stocks and ETFs for new short entries, but they need to correct in one of the ways. When they do, we’ll be ready. But until that happens, we will wait patiently on the sidelines because being in cash is much better than attempting to go long any bounces in a very weak market.

Today’s Watchlist:

There are no new setups in the pre-market. However, we will send an intraday e-mail alert if any ETFs we are stalking hit our trigger price for entry today. Patience to sit in cash until the proper entry points is key so that we don’t chase an ETF on the short side that is already overextended.

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):

Closed positions (since last report):

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

Notes:

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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