Momentum from Monday afternoon’s weakness spilled over into Tuesday’s session, causing stocks to take a step back yesterday. The S&P 500 and Dow Jones Industrial Average surrendered their previous day’s gains, and then some, causing both indexes to register identical losses of 1.2%. Relative strength in biotech and semiconductors helped the Nasdaq Composite to hold up much better. The tech-heavy index gave back just 0.4%. The small-cap Russell 2000 and S&P Midcap 400 indices declined 0.8% and 1.0% respectively. Each of the main stock market indexes closed in the bottom third of its intraday range.
Total volume in the NYSE came in 11% lighter than the previous day’s level, while volume in the Nasdaq declined 9%. The lighter volume losses technically means the S&P 500 and Nasdaq Composite did not mark a bearish “distribution day.” However, recall our discussion from yesterday, where we said that Monday’s increasing volume at the intraday highs was already indicative of “churning,” or institutional selling into strength. Therefore, we would not necessarily expect volume to rise again during yesterday’s losses. Still, it would have been even worse if Monday’s “churning” was followed by a session of higher volume losses. Market internals were not that bad. In the NYSE, declining volume exceeded advancing volume by a margin of 5 to 2, but the Nasdaq adv/dec volume ratio was only fractionally negative.
In yesterday’s Wagner Daily, we suggested “dipping a toe in the water” on the short side of the market. Specifically, we liked the idea of initiating a new short position in the financial sector, as many of the banking and broker/dealer stocks had run into resistance of their recent highs. As for a specific ETF to take advantage of anticipated weakness in the financials, we pointed out the UltraShort Financials ProShares (SKF), which “undercut” its 200-day moving average on Monday. When SKF immediately moved back above its 200-day MA on yesterday’s open, we bought a position. This worked out rather well, as SKF rallied as much as 10.6% intraday before finishing the session with a whopping 8.2% gain. Below is a daily chart of the inversely correlated and leveraged SKF, which moves in the opposite direction of a diverse portfolio of financial stocks:
On the chart above, we have circled the intraday “undercut,” which occurs when a stock or ETF dips below an obvious area of support, but quickly reverses back above it. When I first began my trading career, I frequently made the mistake of initiating a short position as soon as a stock dipped below a key area of support. Had this been nine years ago, I most certainly would have looked at SKF as a short sale going into yesterday’s session, rather than a buy setup. But, through years of experience, I began to learn that such “undercuts,” on the contrary, often presented low-risk buy entries with very positive reward/risk ratios. Why? Because the bears who sell short the breakdowns below support quickly become trapped when the position immediately reverses. This forces them to promptly cover their short positions, which in turn attracts the interest of the bulls who spot a low-risk buy entry.
There is, however, one very important point to making the “undercut” setup work — a buy entry can not be made until the ETF moves back above the key level of support that it broke down below. Waiting for confirmation of the reversal back up into the range prevents you from getting stuck in a breakdown that actually follows through. In this case, SKF needed to rally back above its 200-day MA (at $113.43) before we were interested in buying. Further, notice how a rally back above the 200-day MA also corresponded to a move back above support of the prior consolidation (as annotated by the blue horizontal line). Within the first five minutes of yesterday’s trading, SKF had already popped back above the $114 level, and held, so that gave us the necessary confirmation to buy it. If we drill down to the shorter-term hourly chart interval, notice that SKF has also broken out above its hourly downtrend line, which began with the “swing high” of July 29:
With the “undercut” having firmly resolved itself to the upside, odds are good that SKF should move significantly higher in the near-term. A realistic upside price target is resistance of the July 29 “swing high,” just above the $144 area. However, rather than focusing on a specific price target, we will closely monitor price action along the way, and trail a protective stop in order to maximize gains while protecting our profit. SKF is already showing a gain of 4% (about 5 points) since our buy entry on yesterday’s open, but this ETF is rather volatile in both directions. To compensate for the higher than average volatility of SKF, we simply reduced our position size so that our capital risk is the same as with any other ETF we buy.
Financial stocks were certainly the biggest drag on the broad market yesterday, and may continue to be so in the near-term. The healthcare ETFs, however, continued to show solid relative strength. The iShares Healthcare Sector Index (IYH), which we have been long since August 5, pulled back just 0.5%, and is holding near the top of its recent high. The iShares Medical Devices (IHI), another current market-leading ETF, also eased just 0.5%. The S&P Healthcare SPDR (XLV) pulled back just 0.2%, while the Biotech HOLDR (BBH) showed even more bullish divergence, eking out a small gain of 0.4%. When an ETF continually shows relative strength by losing a lower percentage than the main stock market indexes on broad-based days of losses, the ETF is also likely to outperform the gains of the broad market on the “up” days. This is the whole focal point of my “top-down” strategy of ETF trading, which is detailed in my new book, Trading ETFs: Gaining An Edge With Technical Analysis.
Yesterday’s broad pullback caused both the S&P 500 and Dow Jones Industrial Average to move back below their 50-day moving averages, after trading above them for just one day. As we alluded to in yesterday’s commentary, this was not surprising because the major indices are still in a primary bear market. This does not necessarily mean the counter-trend bounce off the July lows is already finished, but stocks may require a bit of price consolidation at current levels before moving much higher. Nevertheless, stay alert and don’t rule out the possibility that the main stock market indexes could drop back down to test last month’s lows, and do so without much notice. Since we’re basically neutral on the current state of the stock market, we feel that a balanced portfolio with a mix of long and short ETFs is the way to go right now. For long positions, the healthcare sector (first) and non-discretionary consumer goods (to a lesser degree) have the most bullish chart patterns. On the short side (or inversely correlated ETF side), we’re not yet seeing many ideal setups, but financials are probably the best bet.
There are no new setups in the pre-market. We’re playing it conservatively with regard to new positions right now, so we’re okay with having only two open positions at present. As always, we will promptly send an Intraday Trade Alert if/when we enter anything new.
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. Please review the Wagner Daily Subscriber Guide for important, automatic rules on trigger and stop prices.
Open positions (coming into today):
- Per Intraday Trade Alert, we made a judgment call to sell IYT ahead of its original stop. Last Friday’s breakout immediately failed to hold, and IYT began showing way too much relative weakness to the broad market. Rather than take a full loss, it made sense to cut IYT on the first bounce yesterday morning. Cut the losers quickly.
- As per the pre-market plan, we bought SKF when it traded above our trigger price, five minutes after the open.
SKF long (75 shares from August 12) – bought 114.82, stop 105.32, target 144.00, unrealized points = + 4.93, unrealized P/L = + $370
IYH long (250 shares from August 5) – bought 66.67, stop 64.19, target 71.12, unrealized points = + 1.07, unrealized P/L = + $268
Closed positions (since last report):
IYT long (150 shares from August 8) – bought 93.73, sold 90.90, points = (2.83), net P/L = ($428)
Current equity exposure ($100,000 max. buying power):
Edited by Deron Wagner,
MTG Founder and