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Tips for handling a volatile, transitioning market - August 11, 2010

|Includes: SPDR S&P 500 Trust ETF (SPY)

Stocks gapped sharply lower on yesterday's open, oscillated in a sideways range throughout the first half of the day, then reversed to new intraday highs after the 2:15 pm ET Fed announcement on economic policy. However, although the late-day buying interested significantly trimmed the broad market's losses, the major indices still finished substantially lower. The Dow Jones Industrial Average fell 0.5% and the S&P 500 lost 0.6%. The Nasdaq Composite, down 1.9% at its mid-day low, settled with a 1.2% decline. The small-cap Russell 2000 and S&P Midcap 400 indices tumbled 2.0% and 1.3% respectively. The main stock market indexes closed near the upper third of their intraday ranges.

Total volume in the NYSE jumped 25% above the previous day's level, while volume in the Nasdaq swelled 28%. In both the NYSE and Nasdaq, declining volume exceeded advancing volume by approximately 4 to 1. The sharply higher turnover across the board convincingly caused both the S&P and Nasdaq to register a bearish "distribution day," at least the third such instance of institutional selling within the past two weeks. Mutual funds, hedge funds, and other market-moving institutions are apparently getting nervous about key resistance of the June 2010 highs in the major indices. . .and with good reason. While a healthy market can absorb a couple "distribution days" within the course of its uptrend, the presence of four or more days of higher volume selling typically precedes a significant correction in the broad market.

In yesterday's commentary, we said, "Today, the Federal Open Market Committee (FOMC) is slated to release their latest statement on interest rates and economic policy at 2:15 pm ET. As always, be prepared for a great deal of volatility and whippy price action thereafter. Considering how light volume levels have been lately, volatility could be even greater than usual. . . Frankly, a decent 'knee-jerk' pullback as an initial reaction to the Fed announcement would be positive, as it would provide us with a much better reward-risk ratio on a few ETFs we've been monitoring for potential long entry." As anticipated, yesterday's volatility was indeed rather high, and stocks pulled back as well. But now that the Fed meeting is out of the way, the big question on traders' minds is, "What now?"

Frequently, the initial intraday reaction to afternoon Fed announcements turns out to be the opposite of the real reaction, which is commonly seen one to two days later. As such, the price action of stocks over the next few days may determine the broad market's next move in the near to intermediate-term. As the S&P and Nasdaq futures are presently trading approximately 1.5% lower in today's pre-market session, it's looking as though traders and investors may not have been impressed with yesterday's Fed announcement, in which basically no changes to economic policy were given. But rather than attributing the recent market weakness and distribution as a result of the Fed announcement, as the popular financial media will undoubtedly do, the overall technical picture of the broad market over the past several months more accurately summarizes the situation.

Since the beginning of July, we've been saying it's best to maintain a shorter time horizon on all positions, both long and short, because the major indices are not really engaged in a dominant trend. Rather, we've stated the broad market is merely stuck in an "inverse wedge" pattern, marked by a widening, sideways range. We illustrated this pattern in our commentary about one month ago, and the same pattern remains in effect right now. To refresh your mind, here's the "inverse wedge," shown on the daily chart of the S&P 500 Index:

SPX

Given today's sharp gap down in the pre-market, combined with the pattern above, one might conclude the market's next move is a drift back down towards the lower channel support of the "inverse wedge." While a test of the actual July lows may not happen, we do indeed believe the overall reward/risk is at least starting to tip back into favor of the bears. Therefore, there are several things a trader should do to handle this potentially transitioning market. They are:

  • 1.) Consider significantly tightening stops on all long positions with a relatively high correlation to the main stock market indexes. We have just done that by raising our stops in Claymore Global Solar Energy (NYSEARCA:TAN) and Market Vectors Indonesia (NYSEARCA:IDX) to near the break-even level. While we hoped for greater follow-through to the upside, we must take what the market is giving us...which isn't very much lately. On the other hand, ETFs with a low correlation to broad market direction, such as commodity, currency, and fixed-income ETFs, of which we have several, may be more immune to swings in the major indices.


  • 2.) Start dipping a toe in the water in the short side of the market, or at least increase cash exposure. At present, we're still not seeing many ideal short setups that impress us, but that could quickly change with another day or two of moderate weakness. For those who, for whatever reason, prefer not to sell short, a higher cash exposure is an attractive alternative with minimal short-term risk.


  • 3.) Develop an updated watchlist of ETFs with the most relative strength, which can be bought on a substantial pullback to support of, or an "undercut" of, their 20-day exponential moving averages. One must not rule out the possibility the major indices will only pull back for a few days, shaking out the "weak hands," then rip back up, breaking out above their June 2010 highs we've been discussing. In case this happens, one should be prepared to take a shot with buying one or two of the strongest ETFs on a pullback. While these ETFs could fail to hold support and continue much lower, the time to take a calculated risk with these strong ETFs is on a pullback. As traders, we get paid for taking calculated, favorable risks, so one cannot be afraid to do so if the reward/risk ratios are positive.

Regarding the third point above, here are a few strong ETFs on our radar that may soon present us with an ideal buy entry point on a pullback: iShares Thailand (NYSEARCA:THD), iShares Chile (NYSEARCA:ECH), Brazil Small-Cap (NYSEARCA:BRF), and PowerShares Agriculture (NYSEARCA:DBA). As you can see, most of the leading ETFs in the current market are international. Starting with tomorrow's Wagner Daily, after seeing the outcome of today's weak opening session, we'll look at updated charts and potential buy entry points of a few of these ETFs. But at least for now, it's probably a good time to be in "SOH" (sitting on hands) mode.


Open ETF positions:

Long - TLT, IDX, TAN, UNG, UUP
Short (including inversely correlated "short ETFs") - DZZ
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.



DISCLAIMER: There is a risk for substantial losses trading securities and commodities. This material is for information purposes only and should not be construed as an offer or solicitation of an offer to buy or sell any securities. Morpheus Trading, LLC (hereinafter "The Company") is not a licensed broker, broker-dealer, market maker, investment banker, investment advisor, analyst or underwriter. This discussion contains forward-looking statements that involve risks and uncertainties. A stock's actual results could differ materially from descriptions given. The companies discussed in this report have not approved any statements made by The Company. Please consult a broker or financial planner before purchasing or selling any securities discussed in The Wagner Daily (hereinafter "The Newsletter"). The Company has not been compensated by any of the companies listed herein, or by their affiliates, agents, officers or employees for the preparation and distribution of any materials in The Newsletter. The Company and/or its affiliates, officers, directors and employees may or may not buy, sell or have positions in the securities discussed in The Newsletter and may profit in the event the shares of the companies discussed in The Newsletter rise or fall in value. Past performance never guarantees future results.

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Disclosure: Long TLT, Long IDX, Long TAN, Long UNG, Long UUp, Short DZZ