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Keep the bounce in perspective - May 11, 2010

|Includes: iShares Russell 2000 ETF (IWM), IYM, KCE

Recovering most of their losses of the past two days, stocks snapped back from near-term oversold conditions yesterday. The Dow Jones Industrial Average jumped 3.9%, the S&P 500 4.4%, and the Nasdaq Composite 4.8%. The small-cap Russell 2000 and S&P Midcap 400 indices gained 5.6% and 5.2% respectively. However, even though the main stock market indexes closed sharply higher, the entire advance was the result of a massive opening "gap up" in the broad market. Thereafter, stocks merely oscillated in a sideways range for the entire day. As such, actual price action during the entire session was relatively uneventful for traders. The major indices finished near the intraday highs of their horizontal ranges.

Unfortunately for the bulls, volume eased substantially alongside of yesterday's advance. Total volume in the NYSE receded 22%, while volume in the Nasdaq limped in 32% lighter than the previous day's level. One of the most important signs likely to precede a significant bottom in the broad market is the presence of higher volume gains ("accumulation"), which would point to the return of institutional buying. But although yesterday's percentage gains were encouraging, higher volume was a key ingredient lacking from the session. Until the market flashes at least one bullish "accumulation day," bounces in the broad market now cannot be trusted, no matter how substantial the actual gains.

Yesterday's gains of 4-5% must be taken in context with the recent increase in volatility. In more "typical" conditions, such an advance would be spectacular. However, for the most part, yesterday's bounce only recovered approximately two-thirds of last week's losses. Therefore, rather than getting caught up with huge percentage changes from one day to the next, one should be more concerned with relative price movements, using the hourly and daily charts as a gauge. Nevertheless, it's crucial to be aware we're apparently entering a period of much higher than usual volatility, similar to what was experienced in October of 2008, when 5% was a typical one-day percentage change for the major indices. Prudent traders should consider reducing their average position size on all new trades, in order to maintain a consistent capital risk per trade, despite higher volatility in the broad market.

In yesterday's commentary, we pointed out three ETFs as potential short setups on a bounce (IWM, IYM, and KCE). One of those three, iShares Russell 2000 Index (NYSEARCA:IWM), hit our trigger for short sale entry. IYM and KCE also bounced substantially, but remain below our ideal short entry points into resistance. We'll continue monitoring these, and other ETFs, for new short entries. Still, we wish to keep short exposure somewhat conservative for now. On the daily chart below, notice we sold short IWM as it neared major resistance of its 50-day moving average:

IWM

Yesterday's emergency measures by European policy makers to prop up the euro provided a good excuse for stocks to bounce from near-term oversold conditions. But while the initial knee-jerk reaction was positive, will the bounce be sustainable for more than a day or two? Due to the combination of lighter volume on the bounce and the plethora of overhead supply that remains, we remain suspicious. Furthermore, even though the gains of the major indices were in excess of 4%, nothing has really changed on a technical level. The main stock market indexes remain in short to intermediate-term downtrends, with resistance of the 20 and 50-day moving averages still overhead. As such, our near-term plan is still to selectively enter new short positions bouncing into major resistance levels, while waiting for new bases of price consolidation to eventually develop for fresh buy entries sometime thereafter. Overall, until we see the presence of institutional accumuluation, new long positions in ETFs with a direct correlation to the stock market remain risky.


Open ETF positions:

Long - (none)
Short (including inversely correlated "short ETFs") - IWM
The commentary above is an abbreviated version of a daily ETF trading newsletter, The Wagner Daily. Regular subscribers receive daily updates on all open positions, as well as new ETF trade setups with detailed trigger, stop, and target prices. Intraday Trade Alerts are also sent via e-mail and/or text message, on as-needed basis. For your free 1-month trial to the full version of The Wagner Daily, or to learn about our other services, please visit morpheustrading.com.

Deron Wagner is the Founder and Head Portfolio Manager of Morpheus Trading Group, a capital management and trader education firm launched in 2001. Wagner is the author of the best-selling book, Trading ETFs: Gaining An Edge With Technical Analysis (Bloomberg Press, August 2008), and also appears in the popular DVD video, Sector Trading Strategies (Marketplace Books, June 2002). He is also co-author of both The Long-Term Day Trader (Career Press, April 2000) and The After-Hours Trader (McGraw Hill, August 2000). Past television appearances include CNBC, ABC, and Yahoo! FinanceVision. Wagner is a frequent guest speaker at various trading and financial conferences around the world, and can be reached by sending e-mail to deron@morpheustrading.com.



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Disclosure: short IWM