Showing initial signs that the near-term bounce off the January lows may be nearing an end, the major indices declined across the board yesterday. Stocks opened just slightly lower, then drifted south throughout the entire session. The Nasdaq Composite lost 1.3%, the S&P 500 1.1%, and the Dow Jones Industrial Average 0.9%. The small-cap Russell 2000 and S&P Midcap 400 indices shed 1.0% and 0.7% respectively. Each of the broad-based indexes settled near its intraday low.
Turnover in both exchanges dipped below average levels for the first time in weeks. Total volume in the NYSE was 23% lighter than the previous day's level, while volume in the Nasdaq eased 30%. Though stocks fell on lighter volume, that's not necessarily positive in this situation. In bear markets, volume typically declines when near-term bounces run out of gas. The market drifts lower on lighter volume, but the lack of buyers scares the bulls into selling, thereby causing trading activity to increase as the decline picks up steam. This is a different dynamic than bull markets, in which light volume pullbacks off the highs are bullish. The difference is the direction of the primary, long-term trends.
In yesterday's commentary, we said that last week's retracement off the January lows would begin to provide ideal short entry points on select ETFs. We jumped back in the market yesterday with a bearish position in the Financials sector. Rather than selling short, we bought the inversely correlated UltraShort Financials ProShares (SKF). Below is the daily chart of SKF:
As you can see, SKF was in a steady uptrend from October 2007 through the third week of January 2008. Then, when the broad market began to bounce off the lows, SKF corrected sharply (remember it moves inversely to the financial sector). As the near-term rally in financials was happening, you may recall that we even profited with a quick momentum trade on the long side of the S&P Financial SPDR (XLF). But with financials rallying so sharply in such a short period of time, we now expect that sector to be among the first to move back down when the broad market buying enthusiasm dries up. To fine tune our entry point, we drilled down to a shorter term hourly chart, then looked for a breakout above the downtrend line. The breakout came yesterday, thus triggering our long entry. This is illustrated on the hourly chart below:
With this setup, we have placed a protective stop below the February 1 low. Our upside price target is a test of the January high. However, as that's quite a big move, we'll be closely assessing price action along the way. A trailing stop will also be used to protect our gain along the way. The first test of significant resistance in SKF will be the area between the 20 and 50-day moving averages ($103.50 to $105 range).
If you check out the hourly charts of major indexes such as the S&P, Nasdaq, and Dow, you will notice that each closed right at their short-term trendlines off the January 23 lows. As the primary intermediate and long-term trends are "down," we expect a break of those hourly uptrend lines within the next several days. Before yesterday's close, we bought a small position of the inversely correlated UltraShort Dow 30 ProShares (DXD), in anticipation of a rapid breakdown. It's okay if that breakdown doesn't occur yet, as our risk/reward for short entry in the broad market near current levels is quite positive regardless. It's basically akin to buying a healthy pullback in a strongly uptrending stock.
Quick momentum trades on the long side, such as our recent winning trades in the S&P Homebuilders SPDR (XHB) and S&P Financials SPDR (XLF), no longer present a positive risk/reward ratio. With most chart patterns again looking more bearish than bullish, we are no longer looking to buy new ETFs (with the exception of the inversely correlated ProShares). If anything happens in the market that causes us to change our bias, we'll be sure to report it here. Remember to trade what you see, not what you think!