Divergence was the dominant theme in yesterday's market action, as the S&P and Dow bounced slightly off key support levels, but the Nasdaq registered a loss. Following through on bearish momentum from the previous day's losses, all the major indices began the day in firmly negative territory, but reversed later in the afternoon. The S&P 500, down 1.1% at its morning low, managed to close 0.3% higher. The Dow Jones Industrial Average similarly gained 0.5%. Though the Nasdaq Composite finished in the upper quarter of its intraday range, the tech-heavy index still declined 0.5%. Small and mid-cap stocks showed the most relative weakness; the Russell 2000 fell 0.9% and the S&P Midcap 400 lost 0.7%. All the main stock market indexes closed near their intraday highs.

Total volume in the NYSE rose 60% above the previous day's level, while volume in the Nasdaq increased 8%. Not surprisingly, turnover picked up from last week's lazy, pre-holiday pace, but still remained below 50-day average levels. The Nasdaq Composite's loss on higher volume caused the index to register a bearish "distribution day," its fifth such session of institutional selling in recent weeks. However, it was positive that the S&P 500, which already suffered its fifth "distribution day" last week, eked out a modest advance on higher volume. Yet, despite the gains of the S&P and Dow, market internals remained marginally negative. In the NYSE, declining volume exceeded advancing volume by a margin of 3 to 2. The Nasdaq's adv/dec volume ratio was negative by 5 to 2. Still, the volume spreads were much improved from the ugly indications of earlier in the morning.

In yesterday's commentary, we said, "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," which is exactly what happened on yesterday's open. Both indexes briefly "undercut" key support of their June lows (the "necklines" of their head and shoulders patterns) in the morning, then reversed to close higher, and at their best levels of the day. The S&P 500 also bounced off pivotal support of its 200-day moving average. The intraday price action caused the S&P and Dow to form bullish "hammer" candlestick patterns on their daily charts, which is a positive indication for the short-term direction of the market. However, the validity of the bullish "hammers" will not be confirmed until both indexes follow-up yesterday's reversal by closing higher in today's session. Further, with a plethora of overhead supply left behind in the wake of the July 2 selloff, stocks would need to see substantially sharper increases in volume in order to overcome the resistance created by that supply.

Yesterday's slight bounce in the S&P and Dow was not shocking, as the closely-watched support levels of their June lows provided the perfect excuse for bulls to the step up to the plate, despite the previous day's selling. More interesting was the bearish divergence in the Nasdaq. Because the Nasdaq Composite was showing relative strength to the S&P and Dow throughout all of last week, one might have expected the index to turn in the best performance during yesterday's reversal off the intraday lows. Instead, the Nasdaq lagged behind the S&P and Dow for the duration of the session, and failed to even close above its morning high:



If the bulls were counting on the Nasdaq to help move the broad market back up, yesterday's action was not an encouraging sign. If the S&P and Dow resume last week's weakness, and now lack the bullishness the Nasdaq was formerly providing, it would not take much selling pressure to cause the S&P and Dow to slip below their June lows (and "necklines" of their head and shoulders patterns). Furthermore, a close below yesterday's low in the Nasdaq would cause the index to lose support of its 50-day moving average, for the first time in more than three months. Unless stocks follow through with a solid round of gains off yesterday's bullish reversal, the short-term trends remain bearish. The intermediate-term trends are neutral, but a closing break below the June lows in the major indices would quickly change that scenario.

Open ETF positions:

Long - DXD, SKF, SRS, DUG
Short - (all four of our long positions 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.