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Why Now Is The Time To Play Defense In The NASDAQ

|Includes: Invesco QQQ ETF (QQQ)

On September 6, while the NASDAQ Composite was still chopping around in a multi-month range, we wrote an article that listed the top 3 reasons the NASDAQ would soon breakout to a new high.

In the very next trading session, the NASDAQ indeed jumped 1.3% and broke out to a fresh 13-year high, causing our market timing system to immediately shift from "Neutral" to "Buy" mode.

Since then, the NASDAQ has gained 6% and many of our newsletter stock picks have locked in much larger gains ($TAN +44%, $SLCA +43%, $BITA +37%, $YELP +31%, and $LOCK +17%).

But there are KEY WARNING SIGNALS THE NASDAQ RALLY IS RUNNING OUT OF GAS (at least in the near-term). Read on to find out why...

2 Simple Ways To Determine Overall Stock Market Health

Although the bullish bias of the past two months has presented some great opportunities for momentum swing traders, no bull market moves straight up without eventually undergoing substantial corrections along the way (just as bear markets don't fall straight down for too long without large, counter-trend bounces).

Two of the most important technical factors that always play a major role in determining the trend bias of our proprietary market timing model are:

  1. Volume Patterns Are the S&P 500 and NASDAQ Composite generally gaining on higher volume (bullish accumulation days) or selling off on higher volume (bearish distribution days)? The running count of accumulation or distribution days is a key element of the excellent CANSLIM methodology of William O'Neil, and is one of the top factors in determining our overall stock market bias as well.
  2. Leading Stock Performance Perhaps even more important than the volume patterns in the broad market is the performance of leadership stocks. In a healthy market, the best stocks will always outperform the gains of the main stock market indexes by a wide margin (ie. NASDAQ gains 3% for the month, while a bunch of leading stocks zoom 30%-40% higher during the same period). However, in weak or weakening markets, the major averages will outperform (formerly) leading stocks.
Distribution Day Pileup

On November 6, the NASDAQ Composite declined on higher volume, causing the index to suffer another bearish distribution day.

By our count, this is the NASDAQ's sixth distribution day within the past three weeks (the S&P 500 has been acting a little better).

As shown on the daily chart below, there have been four days of churning (higher volume stalling action), plus two more days of heavier volume with a lower close:

In a healthy bull market, a few days of institutional selling within an uptrend is normal and can easily be absorbed by overwhelming demand.

However, when the running count of distribution days exceeds 5 sessions within a 3-4 week period, it is an immediate and very legitimate warning sign to the bulls that a significant stock market correction may be just around the corner.

Leading Stocks Lagging

The high count of distribution days is bearish, but does not trigger a "Sell" signal in and of itself.

For confirmation that the market is poised to pullback, one must also assess the performance of the top-gaining stocks during the current rally.

Unfortunately, leading stocks have already been lagging the broad market for the past several weeks (as initially mentioned back on October 29), and many were also hit hard yesterday (November 6).

Tesla Motors ($TSLA), one of the top gainers of 2013, reported its quarterly earnings and then plunged 15% yesterday.

Mercadolibre ($MELI) similarly plunged 10% after its latest quarterly earnings report, while SolarCity ($SCTY) tanked 14% in (post earnings) after-hours trading yesterday.

The screenshot below shows a few important leadership stocks that took a hit yesterday:

leadership stocks

Another market leader, LinkedIn ($LNKD), is not on the list above, but the stock has already broken down below key intermediate-term support of its 50-day moving average. Next, it could potentially test its 200-day moving average in the coming weeks.

Why Defense Is Now The Best Offense

The combination of a high number of bearish distribution days and sudden weakness in leadership stocks has forced our proprietary timing model out of its two-month old "Buy" mode as of the November 6 close (details of the newly updated trading signal are restricted to actual Wagner Daily subscribers).

Although it's way too early to declare the current rally in the stock market is dead, we simply cannot ignore the fact that the major averages are now leading, while leading stocks are lagging (exactly opposite of what occurs in a healthy market).

Rather than trying to stick with open positions and overstaying our welcome, we are now switching to very tight protective stops on existing swing trades that are in the money.

Additionally, we will be exiting several new positions "at the market" on today's open, as late-stage buy entries tend to get hit the hardest when conditions quickly turn sour.

If you are struggling with the idea of exiting a position you only recently entered, this is simply how it sometimes goes in the business of trading.

We can never predict when leadership stocks will begin to crack, so we must continue buying the best stocks until price and volume action gives us a valid reason not to.

However, once leading stocks start breaking down en masse, it is best to step out of the way in the short-term.

You can always re-enter your positions if they hold up and leading stocks find traction again, but astute traders should now play defense until that happens.

Morpheus has a pretty accurate track record of telling subscribers precisely when to buy, sell, or sit on the sidelines. See for yourself by test-driving The Wagner Daily newsletter today.

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This article originally appeared at MorpheusTrading.com.

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