The Wagner Daily | September 25, 2006

Commentary:

Continued weakness in the Semiconductor Index ($SOX) weighed on the Nasdaq last Friday, but the losses in the S&P and Dow were more subdued. The Nasdaq Composite lost 0.8%, causing the index to close back below its 200-day moving average after trading above it for the past week. The small-cap Russell 2000 showed relative weakness by falling 1.2%, while the S&P Midcap 400 gave up 0.7%. The S&P 500 and Dow Jones Industrial Average closed lower by only 0.3% and 0.2% respectively. A modest wave of buying one hour before the close helped the major indices to finish near the middle of their intraday ranges. For the week, both the S&P and Dow lost 0.4%. The Nasdaq declined 0.7%.

Turnover declined across the board, enabling the markets to dodge a “distribution day.” Total volume in the NYSE was 13% lower than the previous day’s level, as volume in the Nasdaq declined by 17%. Even though the Nasdaq lost 1.5% over the past two sessions, it has done so on lighter volume both days. This is positive because it indicates that institutions have not yet been rushing for the exit doors as the market enters its corrective phase. Nevertheless, the S&P has already had four days of higher volume losses within the past twelve sessions. Market internals were negative in both exchanges, but much worse in the Nasdaq. In the NYSE, declining volume exceeded advancing volume by a margin of less than 2 to 1, but the Nasdaq was negative by a ratio of more than 3 to 1.

One group of exchange traded funds that made a stealth move to the upside last week was the iShares family of fixed-income (bond) ETFs. As the yield on government T-bonds dropped last week, the price of the corresponding fixed-income ETFs rose higher. The iShares 20+ year Treasury Bond Fund (TLT) not only zoomed 2.5% higher last week, but it also broke out above resistance of its primary downtrend line from the high of June 2005. This is illustrated on the weekly chart of TLT below:

Because TLT is a bit extended above its downtrend line, there is not a very positive risk/reward ratio for buying at its current level. However, remember that a prior resistance level always becomes the new support level after the resistance is broken. Therefore, any retracement down to the breakout level of the prior downtrend line would present a low risk entry point on the long side. We would even consider taking a partial position on a 38.2% Fibonacci retracement of last week’s move.

If you’re not familiar with the fixed-income ETFs, you may be interested to know that each one, just like an actual bond, pays dividends to your brokerage account on a monthly basis. Presently, the distribution yield of TLT is 4.63%. When combined with the actual price appreciation that TLT has been showing lately, it may be one of the better ETF positions to own right now. Just be sure to wait for the proper entry point! Patient, disciplined traders are consistently rewarded in the long-term. For a list of the other fixed-income ETFs, download our free Morpheus ETF Roundup guide.

Looking at the hourly chart of the S&P 500, you will notice that the index is in the process of forming the right shoulder of a bearish “head and shoulders” chart pattern. So far, the right shoulder is much lower than the left shoulder, but it could easily bounce higher before going lower. If it doesn’t, that’s even better because it tells us that the S&P is very weak. We have labeled the components of the head and shoulder pattern on the hourly chart below:

The interesting thing about the S&P right now is that the “head” of the head and shoulders pattern also corresponds to a failed breakout to a new 52-week high. The head and shoulders pattern has a higher rate of accuracy when it forms at the top of an uptrend as opposed to mid-trend or anywhere else. The key for this pattern to work is that the S&P must break below its “neckline” at the 1,310 to 1,312 area, presently a pivotal area of short-term support. If the S&P breaks below this level, we should see significant follow-through to the downside. As a rule of thumb, the downside price target on a head and shoulders pattern is equal to the distance from the top of the head down to the neckline. In this case, that equates to an anticipated move of 18 points below the neckline. If you subtract 18 points from the 1,310 support level of the neckline, you get a downside price target of around 1,292. Curiously, the 1,292 area also correlates to support of the prior low fro
m September 7 – 11. The 50-day MA will provide support in that vicinity as well. Isn’t it odd how often technical levels of support and resistance converge with one another?

Obviously, a rally above the top of the head (over 1,329) would completely invalidate the head and shoulders pattern and require us to stop out of any short position in the S&P 500. A rally above the top of the head could generate a lot of upside momentum, so be sure to keep a tight stop over that level in case the pattern fails to follow through. Rather than being short the S&P 500 SPDR (SPY), we are presently long the UltraShort S&P 500 ProShares (SDS) because it provides 2 to 1 leverage, a nice feature for the low volatility broad-based ETFs. Buying SDS instead of selling short SPY also enables one to take a bearish position in a non-marginable account such as an IRA or other retirement account.

Today’s Watchlist:

There are no new setups, as we are near our maximum buying power based on the $50,000 model account. Instead, we will focus on managing our existing positions for maximum profitability.

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):

unrealized P/L = + $920

SMH short (500 shares from September 18 entry) –
sold short 34.84, stop 34.88, target 32.15, unrealized points = + 1.49, unrealized P/L = + $745

SDS long (500 shares from September 21 entry) –
bought 66.16, stop 64.85, target 70.15, unrealized points = + 0.59, unrealized P/L = + $295

XHB long (350 shares from September 13 entry) –
bought 32.85, stop 30.71, target 37.60, unrealized points = (0.02), unrealized P/L = ($7)

Closed positions (since last report):

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

$95,091

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