Stocks followed up Monday's quiet session with a round of higher volume selling, as mutual funds, hedge funds, and other institutions sold into the market's recent strength. The major indices got off to a lower start, drifted lower at mid-day, then oscillated in a tight range throughout the afternoon. The S&P 500 lost 2.0%, while both the Nasdaq Composite and Dow Jones Industrial Average fell 1.7%. The small-cap Russell 2000 and S&P Midcap 400 indices declined 3.2% and 2.6% respectively. All the main stock market indexes closed near their intraday lows.

Total volume in the NYSE jumped 19% above the previous day's level. Nasdaq volume similarly swelled 23%. The stock market's losses on significantly higher volume caused both the S&P 500 and Nasdaq Composite to register a bearish "distribution day." Still, it was the first clear instance of institutional selling in more than two weeks. An occasional round of distribution is to be expected, even in the strongest of rallies, but the presence of two or more additional sessions of higher volume selling in the coming weeks would be a warning sign to the bulls. Despite the sizeable losses in the broad market, market internals were actually not that bad. In both the NYSE and Nasdaq, declining volume exceeded advancing volume by just 2 to 1.

In yesterday's Wagner Daily, we said of the market's current uptrend, "But one thing we don't like is that the major indices have been rallying into quarterly earnings season, which kicks into full swing this week. This is potentially negative because optimistic expectations of earnings reports that may be better than expected are now being built into the price of stocks. This means stocks may need to report positive earnings surprises just to maintain their current prices. Otherwise, there's likely to be post-earnings selling into strength." This exact scenario, played out by Goldman Sachs (GS) yesterday, was a likely trigger to the sell-off.

Even though Goldman Sachs (GS) more than doubled Wall Street's quarterly earnings expectations, the stock plunged 11.6% yesterday, dragging down the entire financial sector and broad market as well. Although a decline of nearly 12% may seem pretty bearish, it's important to keep the overall context of the situation in mind. In just over a one-month period, since its March 9 low, GS rallied a whopping 78%! Therefore, putting yesterday's decline in perspective, it only equated to a price retracement of just over 25% (from the March low to April high).

After yesterday's close, Intel (INTC) surprised Wall Street by more than tripling earnings expectations. Yet, guess what happened to its stock price in after-hours trading? It was last trading nearly 5% below Tuesday's closing price. Again, not surprisingly, Intel had previously trended steadily higher into its earnings report, gaining 28% since its March low. As with Goldman Sachs, the initial reaction to Intel's better than expected earnings numbers was not encouraging.

Based on early evidence of post-earnings selling into strength, as well as yesterday's "distribution day," the broad market could be setting up for a substantial pullback. Without even looking at a chart, it's fair to say a pullback of one-third to one-half of the major indices' gains, from their March lows to April highs, would not be shocking. Interestingly, a 38.2% Fibonacci retracement in the S&P 500 presently converges with the 50-day moving average. This is shown on the daily chart below:



If stocks continue selling off in the short-term, look for that 789 area in the S&P 500 to be a key level of price support. If the S&P retraces to that level and doesn't flash any major signs of distribution in the process, new pullback buying opportunities could be created in ETFs that have been showing the most relative strength on the way up. Of course, there's also the possibility stocks will correct by time, merely trading in a sideways range for several weeks instead. Either way, the point is to be on guard for further selling in the near-term. The intermediate-term outlook, however, still looks bullish. We'll be closely watching for ideal pullback entries in strong ETFs in the coming weeks.

Open ETF positions:

Long - TAN, OIH, UGA, USO, SLV, UDN
Short - (none)

Deron Wagner is the Founder and Head Trader of both Morpheus Capital LP, a U.S. hedge fund, and Morpheus Trading Group, a trader education firm launched in 2001 that provides daily technical analysis of the leading ETFs and stocks. For a free trial to the full version of The Wagner Daily or to learn about Wagner's other services, visit MorpheusTrading.com or send an e-mail to deron@morpheustrading.com.