Table of Contents


• Broad Market Analysis - Sector rotation in flat markets
• MTG Stalk of the Week - TNH long
• ETF Trend Tracker weekly commentary

The major indices got off to a weak start yesterday morning, but support of the hourly uptrend lines in the S&P and Dow helped the broad market to rebound by mid-day. Continued relative strength in the tech arena pushed the Nasdaq higher, but relative weakness in several industries held the other main indexes down. The Nasdaq Composite gained 0.6%, the Dow Jones Industrial Average edged 0.1% higher, and the S&P 500 was unchanged. The small-cap Russell 2000 and S&P Midcap 400 indices were lower by 0.4% and 0.1% respectively. Most of the broad-based indexes settled near their intraday highs.

Turnover was basically on par with the previous day's levels. Total volume in the NYSE declined 2%, while volume in the Nasdaq was flat. Given that the S&P 500 was only unchanged, it's positive that trading activity failed to tick higher. However, higher volume in the Nasdaq would have helped to confirm the gains in that exchange. Like the closing prices, market internals were mixed. In the NYSE, declining volume marginally exceeded declining volume. Total volume in the Nasdaq outpaced declining volume by just under 2 to 1.

We closed out two of our ETF positions for solid gains into Monday morning's strength, as both had rallied into resistance levels. First, we sold our long position in the Oil Service HOLDR (OIH), which had run into the upper channel resistance of its intermediate-term uptrend. Closing the position on the open, we netted a quick gain of 5% (9 points) since our September 18 breakout entry. The daily chart below illustrates the uptrending channel of OIH:

When a stock or ETF rallies into resistance of its uptrending channel, it does not necessarily mean it will automatically pull back to the lower channel support. Positions with relative strength will often ride the upper channel for days, or even weeks. However, our initial plan with this setup was just to trade momentum to a new high from the September 18 breakout. At this point, the reward/risk ratio for further gains without first having a short-term correction is negative. As such, we informed subscribers to The Wagner Daily that we would be selling into strength of the recent gains, rather than waiting around for a pullback. OIH subsequently moved three points lower after Monday morning's exit.

In addition to OIH, we also took profits on our PBW position on Monday. We bought PBW when it broke out above resistance of both its 50-day MA and intermediate-term downtrend on September 18. Though we intended to hold the trade to a new high, it moved very rapidly up to an area of horizontal price resistance from July of this year. This is shown below:

As you can see, Monday's high in PBW exactly matched resistance of the July high. This is similar to how the September 19 high in the S&P 500 coincided with prior resistance from June (as shown in the July 24 issue of The Wagner Daily). We sold PBW just five cents below Monday's high, netting a gain of 6.6% (1.42 points) on the four-day hold.

Because of its relative strength, PBW should still be able to break out above resistance of the $22.89 level in the near future. However, it may first correct by either time or price. We plan to watch PBW for a potential re-entry point after it forms a base of support and subsequently rallies above Monday's high.

Over the past five days, the main stock market indexes have been in a relatively tight, sideways range, but substantial "behind the scenes" moves have been taking place within specific industry sectors. This is primarily because mutual funds, pension funds, and other institutions have bylaws that require most of their assets to be invested in the stock market at all times. As such, they obviously put their buying power into the sectors and indexes they feel have the best chance of price appreciation. Conversely, they liquidate holdings they feel have limited chance of going higher. This constant movement of funds out of one sector and into another is known as institutional sector rotation, and is the reason why at least one or two sectors will always show relative strength or weakness to the broad market, regardless of what type of trend the major indices are involved in. Sectors with relative strength can generate double digit percentage gains, even while the S&P and Nasdaq are unchanged.

Sectors and indexes with relative strength rise at a higher percentage than the broad-based indexes in uptrends, while they also fall less than the major indices in periods of downward price movement. If a sector is so strong that it simply moves sideways while the broad market is moving lower, what do you think happens when the major indices eventually bounce? It will usually be the first sector to shoot to a new high. If a new downtrend suddenly starts, the sector with relative strength will also be the last to fall. These are the ones we want to buy because not only is the upside profit potential greater, the downside risk is also lower.

In confirmed broad-market downtrends, we inversely want to be positioned short in ETFs with the most relative weakness to the broad market. They will be the last ones to rise when the market does, and will also fall at a greater pace than the major indices, thereby yielding greater profit potential.

The first step of sector trading ETFs is creating a daily watchlist of the main industry sector indexes, which enables you to quickly spot the indexes that are showing the most divergence (relative strength) to the broad market. The quickest way to do this is by sorting the list of industry sectors by percentage change. Below is a screenshot of our sector watchlist, sorted by daily percentage change. We use a package called TradeStation for our charting, but there are many others with similar features:

If looking for sectors with bullish trend divergence, pay attention to how each index acts whenever the S&P or Nasdaq makes a move. Sectors with relative strength will usually go sideways to slightly higher when the S&P or Nasdaq drops, but will rocket to new highs on the slightest bounce in the broad market. Conversely, short candidates should barely lift off their lows when the S&P and Nasdaq rallies, and should fall to new lows on any broad market weakness.

Upon getting in the habit of scanning your sector watchlist daily, you will quickly learn to spot divergent prices patterns in the broad market. Within the sector indexes, we then want to buy the specific sector ETFs with the most bullish divergence (relative strength) and/or short those with the most bearish divergence (relative weakness) to the broad market. To easily see a list of ETFs within each sector, we suggest downloading the free Morpheus ETF Roundup, then looking up the applicable sector.

The best way to catch divergent trends in the early stages is to become disciplined at scanning your watchlist at a regular interval, depending on the type of trader you are. If you are looking for trades with a three to five day time horizon, for example, you would want to scan for sector trend divergence on a daily basis. But traders looking to enter trades with a one to three month time horizon would benefit more from doing scans that show weekly relative strength of the sectors instead of daily. The frequency with which to look for divergent trends depends on what type of trader you are. Daytraders may prefer to follow the percentage changes on an intraday basis, while longer-term trend traders (such as the Morpheus Capital hedge fund) will look for relative strength on an end-of-day or weekly basis. Regardless of the time horizon you trade, the concept works the same. However, greater trend divergence that results in larger profit potential will obviously come from the longer time periods. When you spot these divergent trends early enough, you can enter the trade, then simply trail stops to maximize your profits as long as the relative strength remains intact.

One final note regarding the screenshot above is the column labeled "% range." In addition to simply plotting percentage price changes, we also like to see where each sector index closed the week (or day) relative to its range of that time interval. The closer each index closed to the top of its range, the more relative strength it is showing. Conversely, indexes that close near the bottom of their ranges are showing the most relative weakness. After getting in the habit of scanning all your sector indexes at a regular interval which you determine, the divergent trends will become apparent. If the same indexes are showing bullish or bearish divergence every time you do your research, a longer-term trend divergence that occurs from institutional sector rotation is probably taking place. Buying the sector ETFs with bullish trend divergence and shorting those with bearish divergence enables you to ride along on the coat tails of institutions who also realize the benefits of sector trading with ETFs. To learn more about this strategy, keep an eye out for my brand new book on ETF trading, scheduled to be published by Bloomberg Press in early 2008.

If you wish to learn about Morpheus Trading Group's ETF trade entries on the same day they occur, sign up for a free trial to The Wagner Daily or other MTG services by clicking here (limit one per household). Also, remember that all previously published issues of both The Wagner Daily and The Wagner Weekly are available in the MTG archives. If you are new to our services or wish to broaden your knowledge of ETF trading or our general trading style, we recommend you browse the archives because it is educational and free! Click here to visit the Wagner Daily archives or here to visit the Wagner Weekly archives.

In this column, MTG presents you with a FREE, actual trade setup that we are stalking for entry at some point during the week. Note that, unlike the daily guidance that regular Stalk Sheet subscribers receive, this free Stalk of the Week does not take into account overall broad market conditions that can easily affect the trade over the next several days. This week's setup is: