The Wagner Daily | March 7, 2007

Commentary:

Stocks staged a broad-based rally from short-term oversold conditions yesterday, but lower turnover pointed to a lack of institutional demand. The broad market gapped higher on the open, drifted modestly lower in the morning, then rallied to new highs in the afternoon. The Nasdaq Composite gained 1.9%, the S&P 500 advanced 1.6%, and the Dow Jones Industrial Average closed 1.3% higher. Just as small-cap stocks lost more than mid and large-cap stocks during the selloff, they also bounced the most yesterday. The small-cap Russell 2000 surged 2.5%, while the S&P Midcap 400 gained 1.6%. A pullback in the final thirty minutes of trading caused the major indices to finish below their best levels, but still in the upper 20% of their intraday ranges.

The percentage gains of yesterday’s rally were solid, but higher volume was one key element that was lacking. Total volume in the NYSE declined by 7%, as volume in the Nasdaq came in 8% below the previous day’s level. Strong gains on higher volume would have indicated the rally was supported by institutional buying, but the lower volume tells us that mutual, hedge, and pension funds primarily remained on the sidelines. Instead, yesterday’s gains were most likely the result of both retail “bargain hunting” and traders covering their short positions, which in turn triggered more short covering as the session wore on. Typical of rallies that are largely driven by short covering, market internals were very strong. Advancing volume in the NYSE exceeded declining volume by a margin of 14 to 1. The Nasdaq ratio was positive by 16 to 1.

In yesterday’s newsletter, we mentioned the likelihood of a substantial bounce in the markets, and looked at technical resistance levels the S&P and Nasdaq were likely to see. The first line of resistance in both indices was their respective 23.6% Fibonacci retracement levels from their February 22 highs down to their March 5 lows. Reinforcing the power of Fibonacci as a technical analysis tool, the 23.6% retracements is exactly where both the S&P and Nasdaq ended up yesterday. Below are the updated hourly charts of both indices:

As you can see, both the S&P 500 and Nasdaq Composite rallied to close at or just above their respective 23.6% Fibonacci retracements. The 40-period moving averages, which converged with the 38.2% retracement levels yesterday, have also descended to meet the price of the indexes. In overly bullish or bearish markets, 23.6% is often the highest retracement that an index will see before resuming its prior trend (a downtrend in this case). A more moderately trending market, however, will retrace up to the 38.2%, or even 50%, before resuming the primary trend. Therefore, the price action over the next several sessions will tell us a lot. If the major indices fail to close above yesterday’s highs within the next one or two days, the probability of another sell-off within the next week is much greater. Conversely, a convincing move above yesterday’s highs will likely send the major indices up to their 38.2% retracements before going much lower.

Using technical analysis to determine probable reversal points in the market is important because it enables you to both sell long positions at an ideal price and enter new short positions at the best risk/reward levels. When the stock market suffers vicious drops such as last week’s, it normally requires at least one to two months of weakness before institutions aggressively step in and begin to move the markets higher again. It’s obviously not impossible for the major indices to quickly move back above their 50-day moving averages, but is highly unlikely due to the vast amount of technical damage left behind in the wake of a free-falling market. Investors who still have not sold their positions since the sell-off began on February 27 are now in “hope” mode. On any rally that approaches their original entry prices, you can be assured they will be selling their stocks in a valiant attempt to “just break even.” This mass thought process is the psychology behind what creates overhead supply and horizontal price resistance levels.

Clearly, a lot of overhead supply awaits the market on any further rally attempts, so consider using that to your advantage by selling short into strength. Now that a recovery attempt is under way, a simple technique for proper short entries is to wait for one of the major indices to trade below its prior day’s low. This type of short entry may be lower risk than selling into strength because it forces the market to confirm that downward momentum has returned.

Today’s Watchlist:

Now that the market has begun to recover off the lows, we are stalking the other broad-based ETFs for potential short entry when upside momentum dries up. Basically, we are looking for breaks of the hourly uptrend lines for new short entries. It will probably take another day or two for clearly defined short entries to present themselves, but we will send an intraday e-mail alert if/when we spot any opportunities for entry today. As for long positions, too short of a time horizon is currently required in order to swing trade that side of the market. Because we expect another leg down in the intermediate-term, a high level of caution should be observed with any long positions.

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 = + $126

UTH short (100 shares from March 5 entry) – sold short 133.18, stop 137.59, target 125.10, unrealized points = (0.52), unrealized P/L = ($52)

Closed positions (since last report):

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

$31,610

Notes:

Please check out the Wagner Daily Subscriber Guide to learn how to get the most from your subscription.

Edited by Deron Wagner,
MTG Founder and
Head Trader