A positive earnings report from Apple (AAPL) helped stocks open slightly higher yesterday morning, but traders immediately sold into strength. The major indices trended steadily lower in the morning, found support at mid-day, then reversed a small portion of their intraday losses in the afternoon. The Dow Jones Industrial Average fell 0.5%. The S&P 500 and Nasdaq Composite posted identical losses of 0.6%. Small-caps showed relative weakness again, as the Russell 2000 slid 1.4%. The S&P Midcap 400 was lower by 0.9%. All the main stock market indexes closed between the bottom third and middle of their intraday ranges.

On the surface, yesterday’s percentage losses were relatively moderate. However, it was bearish that higher volume accompanied the losses. Total volume in the NYSE swelled 15% above the previous day’s level, while volume in the Nasdaq ticked 11% higher. The broad-based losses on increasing volume caused the S&P 500 to suffer its seventh “distribution day” in recent weeks. The Nasdaq registered its fourth day of institutional selling within the same period. A healthy market can typically absorb a few days of higher volume losses over a three to four week period, but five or more “distribution days” often overpowers the buyers, leading to a significant correction in the market. Since yesterday marked the seventh day of institutional selling in the S&P within the past month, astute traders will use caution on the long side of the market right now.

After retracing lower in the latter half of September, many ETFs mirrored the major indices by coming into support of their 50-day moving averages at the beginning of October. Virtually all of them subsequently bounced higher, but not all of them overcame their prior highs to set new 52-week highs. The ETFs that failed to breakout to new highs have significantly lagged the S&P, Dow, and Nasdaq, and could be said to have short-term relative weakness. If the broad market starts building on yesterday’s losses, ETFs that lagged on the way up will likely be the first to break down lower. The iShares DJ Real Estate Index Trust (IYR) is one such ETF that has the potential to show downside leadership. The “percentage change chart” below compares the performance of IYR to the S&P 500 since the beginning of the month:


While the S&P 500 is presently showing a month-to-date gain of 4.6%, IYR has increased only 0.8% during the same period. But more important than the substantial difference in performance is the recent divergence of IYR’s price pattern. On the chart above, the annotations “1” and “2” indicate where the S&P 500 (the blue line) made two successive “higher highs” within its short-term trend, but IYR (the red line) made two “lower highs” instead. Furthermore, notice that IYR has already fallen to nearly test its prior “swing low” from October 13. The S&P 500, on the other hand, is still well above its October 13 low. There’s even the right shoulder of a “head and shoulders” pattern forming on the hourly chart of IYR. When an ETF trades sideways to lower, as the broad market moves higher, that ETF is usually the first to plunge lower when the overall market eventually pulls back. Next, let’s take a look at the daily chart of IYR:


If IYR breaks below its three-day low of $41.83, just below yesterday’s low, it will lose support of its 20-day exponential moving average (the beige line). Combined with the relative weakness shown in the first chart above, such a break of support could easily lead to a rapid breakdown below the 50-day moving average this time around. If a trader wanted to initiate a short sale in IYR, scaling into the trade is a good way to reduce risk, just in case the 50-day MA manages to hold up again. A partial position could be sold short below the three-day low (around $41.75), with the remaining shares being added on the confirmed break of the 50-day MA (around $41.25). As for a realistic downside target, the dashed, horizontal line marks a major area of support that would be a logical place to take profits on a short position. As an alternative to selling short IYR, one might consider buying the inversely correlated UltraShort Real Estate ProShares (SRS) (which we plan to do if it rallies above yesterday’s high). Just realize many of the UltraShort ETFs underperform their underlying indexes over the intermediate to long-term. For short-term, momentum-driven trades, they are often ideal trading vehicles.

Yesterday, we sold our position in First Trust Natural Gas (FCG) for a nice profit of 14%, and with a holding period of approximately three weeks. Though FCG is still trading near its recent high, we were using the 20-period EMA on the hourly chart as a guide to trail a tight stop. We took profits on the trade when FCG broke the $18.37 level, but it will remain on our watchlist for potential re-entry on a pullback. Separately, we entered a new long position in Claymore Global Shipping (SEA), which we analyzed in the October 19 issue of The Wagner Daily. Although the broad market showed weakness yesterday, individual stocks in the shipping sector showed solid relative strength and positive money flow. SEA, for example, only edged 0.1% lower.

In our October 20 commentary, we cautioned that the major indices moved to new highs of the year on Monday, but did so on very light turnover. When that happens, it only requires a small amount of selling pressure to undo the light-volume gains, which is essentially what happened yesterday. Now, it would only require a minimal amount of additional selling to send the main stock market indexes back below their September highs. Such action would have negative implications for the broad market’s short-term trend, as the major indices would then be in danger of undergoing “failed breakouts” at new highs. Below, we’ve annotated this on the daily chart of the S&P 500 SPDR (SPY):


Certainly, a single day of losses does not mean the stock market is about to enter into a substantial pullback. But with the S&P showing seven “distribution days,” and also trading within just a few percent of its long-term, two-year downtrend line, a healthy dose of caution is definitely in order. The inability of the Russell 2000 to overcome its September highs also remains a concern. Still, it’s way too early (and risky) for aggressive short selling at current levels. However, “dipping a toe” on the short side of the market, as we may do with the Real Estate sector today, is a good way to hedge the risk of any long positions you may be carrying. For now, our overall short-term market bias is neutral. Most of our positions are commodity-related, which gives us a low correlation to the direction of the broad market.

Open ETF positions:

Short – (none)

NOTE: Regular subscribers to The Wagner Daily receive daily updates on the open positions above, as well as new ETF trade setups, including trigger, stop, and target prices. Intraday Trade Alerts are also sent via e-mail and/or mobile phone text message on as-needed basis.

Deron Wagner is the head trader of Morpheus Capital Hedge Fund and founder of Morpheus Trading Group (morpheustrading.com), which he launched in 2001. Wagner’s new book, Trading ETFs: Gaining An Edge With Technical Analysis, was published by Bloomberg Press in August, 2008. Wagner also appears on his best-selling video, Sector Trading Strategies (Marketplace Books, June 2002), and is 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. He is also a frequent guest speaker at various trading and financial conferences around the world.

For a free trial to the full version of The Wagner Daily above, which includes detailed ETF trade setups and daily position updates, or to learn about our other newsletters, visit morpheustrading.com or send an e-mail to deron@morpheustrading.com.