After chopping around during most of the holiday-shortened week, stocks nosedived last Thursday, tipping the balance of power in favor of the bears. The major indices gapped sharply lower on the open, then drifted sideways to lower throughout the rest of the session. By day's end, key technical support levels were broken, and the main stock market indexes had each fallen several percent. The Dow Jones Industrial Average tumbled 2.6%, the S&P 500 2.7%, and the Nasdaq Composite 2.9%. The small-cap Russell 2000 and S&P Midcap 400 indices plunged 3.9% and 3.3% respectively. All the broad-based indices closed at their dead lows of both the day and week.

Total volume in the NYSE receded 25%, while volume in the Nasdaq was 2% lighter than the previous day's level. Considering the sharp losses in the broad market, it's positive that volume levels remained tepid. However, remember that turnover is typically light ahead of three-day holiday weekend regardless. In our July 1 commentary, we warned that the S&P 500 registered its fifth consecutive "distribution day" (loss on higher volume) in the preceding session. Specifically, we said, "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." Traders who heeded that reliable warning of five "distribution days" were indeed rewarded the very next day, as stocks got hammered across the board.

In addition to discussing the stock market's bearish volume patterns in the July 1 issue of The Wagner Daily, we also brought to your attention the bothersome "head and shoulders" patterns that were forming on the daily charts of the S&P 500 and Dow Jones Industrial Average. At the time, both indices were forming "right shoulders," and we pointed out that a breakdown below their "necklines" would probably lead to a swift change of overall market sentiment. Despite last Thursday's selloff, both indexes are still holding above their "necklines," but only marginally. The S&P 500 is now less than 1% above its "neckline," and the Dow is only 0.3% above its "neckline." Further, both indexes have fallen back below their 50-day moving averages, while the Dow has firmly moved back below its 200-day MA as well. As such, odds are now pretty good the S&P and Dow will test critical support of their "necklines" (which is the same as their respective June 2009 lows) within the next day or two. In case you missed the original write-up on the "head and shoulders" patterns, you may want to review our July 1 commentary, which you can do by clicking here.

Over the past several weeks, it has been difficult to find clear sector leadership, with the possible exception of healthcare. It has, however, been getting easier to spot industries with relative weakness to the broad market. Financial, Energy, and Retail sectors are all showing relative weakness. Since all the main stock market indexes are still above their "swing lows" from late June, any sector indexes or ETFs already trading below their closing lows of June could be defined as having relative weakness to the broad market. If short-term sentiment remains bearish going into the new week, expect these sectors to show leadership to the downside. Below is a daily chart of the S&P 500 SPDR (SPY), a popular ETF proxy of the benchmark S&P 500 Index, as well as charts of iShares Regional Banks (IAT), S&P Energy SPDR (XLE), and the Retail HOLDR (RTH). Notice how SPY is still (barely) holding above its late June closing low (which is also its "neckline"), but IAT, XLE, and RTH have all broken down to new closing "swing lows:"









Any ETFs that have already broken down below their June lows, such as IAT, XLE, and RTH, have now entered into intermediate-term downtrends, as they have formed significant "lower highs" and "lower lows" on their daily charts. As with our new downside expectations of the broad market (as per our July 1 commentary), this does not mean these ETFs will fall all the way back to their March 2009 lows. However, retracements of half to two-thirds of their gains (from the March lows to June highs) is statistically likely. A test of the March 2009 lows is certainly not out of the question, but a more realistic downside target, at least in the short-term, is a two-thirds retracement of their gains off those lows. Presently, we're positioned in "short ETFs" that track the Dow Jones Industrials (DXD), Financials (SKF), Real Estate (SRS), and Energy (DUG), each of which is now showing an unrealized gain.

Obviously, the possibility exists that the market will surprise us by quickly snapping back to recover last Thursday's losses. But even if it does, sectors and ETFs with relative weakness should recover at a much slower pace, and with less intensity, than the main stock market indexes. For that reason, short positions should be in sectors exhibiting relative weakness to the broad market, not strong sectors one merely thinks should "catch up" to the weakness in the other sectors. If you make it a habit to always trade what you see, not what you think, you'll stay out of trouble while other traders follow the dismal path of "hope."

Open ETF positions:

Long - IBB, SRS, SKF, DUG, DXD
Short - All positions except IBB are inversely correlated "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.