Stocks concluded the last day of the first half of 2009 on a negative note, as the major indices sold off on higher volume. The bulls attempted to build on the previous day's strength in the first half hour of trading, but a worse than expected consumer sentiment report at 10:00 am ET sparked a sudden reversal of fortune. One hour later, the main stock market indexes had fallen to the previous day's lows, where they found support throughout the rest of the day. A little bounce in the final ninety minutes of trading lifted stocks off their worst levels of the day, but the major indices still closed in the bottom third of their intraday ranges. The Nasdaq Composite lost 0.5%, the S&P 500 0.9%, and the Dow Jones Industrial Average 1.0%. The small-cap Russell 2000 and S&P Midcap 400 indices posted matching declines of 0.4%. For the choppy, range-bound month of June, the Nasdaq Composite gained 3.4%, the S&P 500 was unchanged, and the Dow Jones Industrial Average lost 0.6%.

Turnover swelled 22% in the NYSE, causing the S&P 500 to register its fifth "distribution day" in recent weeks. Total volume in the Nasdaq was only fractionally higher than the previous day's level. When the market sells off on higher volume, it indicates selling amongst mutual funds, hedge funds, and other institutions. An occasional bout of such distribution is normal, and can usually be absorbed by a healthy market. However, the presence of five or more days of institutional selling within a period of several weeks very frequently leads to a substantial correction in the broad market. While negative volume patterns alone may not be sufficient cause to blindly sell long positions, astute traders heed the legitimate warning signal of numerous "distribution days" by tightening stops and holding off on entering new positions until the underlying market internals improve. Volume is one the most reliable technical indicators at our disposal because it is the footprint of institutional trading activity, which represents more than half of the market's volume on any given day. Unlike moving averages, which are lagging indicators, volume is a leading indicator; hence it never lies.

In mid-June, the major indices entered into a short-term correction off their highs. In the middle of last week, stocks began rebounding from the lows of that pullback, but they gave back part of those gains from that bounce yesterday. On the daily charts of the S&P 500 and Dow Jones Industrial Average, this has led to the formation of a topping pattern known as a "head and shoulders". Presently, the "right shoulders" are being developed, so a break below the "neckline" (last week's lows) would indicate follow-through on the pattern. Below, we've labeled the elements of the current "head and shoulders" formations on the S&P and Dow (regular moving averages have been removed for better visibility of the pattern):





If the S&P and Dow are unable to move higher in the coming days, the highs of their "right shoulders" will remain below the highs of their "left shoulders," thereby increasing the chance of bearish follow-through. If, however, the indexes manage to close significantly higher than the highs of the "left shoulders" (930 for the S&P 500 and 8,587 for the Dow), odds of breaking down below the "necklines" will be diminished. Obviously, a rally back above the June highs would be rather bullish, and would completely invalidate the "head and shoulders" formations.

When a "head and shoulders" pattern follows through to break below its "neckline," the projected price target is a drop equal to the distance between the top of the "head" and the "neckline." For the S&P 500, that equates to a drop of approximately 8% below the "neckline," around the 810 level, if the index breaks below its "neckline" in the first place. For the Dow, the projected drop would be 7% below its "neckline," or around the the 7,650 area. With both indexes, their downside price targets would be roughly equal to a 50% retracement of their gains from the March 2009 lows to their June 2009 highs.

The Dow's current formation of its "right shoulder," resistance of its 200-day moving average, and its fifth "distribution day" in recent weeks provided numerous technical reasons to initiate a new, bearish position in the blue-chip index yesterday. Rather than actually selling short the Dow Jones DIAMONDS (DIA), we bought an inversely correlated "short ETF," the UltraShort Dow 30 ProShares (DXD). Since the Dow is forming a bearish "head and shoulders" pattern, DXD is conversely forming a bullish "inverse head and shoulders" pattern.

Although the "head and shoulders" patterns of the S&P and Dow may be ominous indications of their intermediate-term trends if last week's lows are broken, we're certainly not suggesting the March 2009 lows will be broken anytime soon. In fact, we'd be surprised if the indexes give back more than half of their gains from the uptrend off the March lows, before heading back up. There's also the possibility that the relative strength of the Nasdaq will prevent the S&P and Dow from even following through to break below their "necklines" in the coming days. Still, the reality is a 50% retracement would actually be quite beneficial for the longer-term health of the overall market. Markets that go up too far, too fast, without correcting along the way, are less likely to retain those gains when the inevitable pullbacks come.

Open ETF positions:

Long - IBB, UNG, SKF, DXD, DUG
Short - (none, but SKF, DXD, and DUG are "short" ETFs)

Deron Wagner is the Founder and Head Trader of both Morpheus Capital LP, a U.S. hedge fund, and MorpheusTrading.com, a trader education firm.