After a short-lived reversal attempt in the previous day's session, stocks resumed last week's bearish momentum, causing the major indices to suffer substantial, broad-based losses in yesterday's session. The main stock market indexes opened only slightly lower, but the bears quickly took control, sending the broad market into a steady downtrend that persisted throughout the entire session. The Dow Jones Industrial Average fell 1.9%, the S&P 500 2.0%, and the Nasdaq Composite 2.3%. The small-cap Russell 2000 and S&P Midcap 400 indices plunged 2.0% and 2.2% respectively. Each of the major indices finished below both its prior day's low and intraday low..

Total volume in the NYSE was 3% lighter than the previous day's level, while volume in the Nasdaq declined 2%. The lighter volume enabled both the S&P and Nasdaq to avert another bearish "distribution day," but the running count of institutional selling days becomes less relevant after the NYSE and Nasdaq have already registered five or more "distribution days" within a period of several weeks (which both exchanges have). In both the NYSE and Nasdaq, declining volume exceeded advancing volume by a margin of more than 5 to 1, an indication of steady, yet controlled, selling. "Panic selling," which typically precedes a significant bottom, is usually marked by much worse market internals.

In yesterday's Wagner Daily, we warned of placing too much confidence in the previous day's price action by saying, "the validity of the bullish "hammers" (formed on July 6) will not be confirmed until both indexes follow-up yesterday's reversal by closing higher in today's session." We then summed up our commentary by saying, "If the bulls were counting on the Nasdaq to help move the broad market back up, yesterday's (July 6) 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." Indeed, the scenario has changed, as the main stock market indexes broke below their June lows yesterday, dragged down by the Nasdaq closing below its 50-day moving average for the first time since March 20. Overall, yesterday's market action can be summed up in two words: bearish confirmation.

For the past week, we've been discussing the bearish "head and shoulders" patterns that were forming on both the S&P and Dow. On the morning of July 6, both indices tested key support of their "necklines," but the subsequent afternoon recovery off the lows hinted at continued indecision, and a tug-of-war between the bulls and bears. However, now that both indexes have convincingly closed below their "necklines," which is also the prior "swing lows" from June, the stock market is more clearly showing its intentions by confirming the bearish patterns of the major indices. Since the Nasdaq also sliced through support of its "swing low" from June, all the main stock market indexes have now technically entered into intermediate-term downtrends, as they have formed signficant "lower highs" and "lower lows" on their daily charts.

Although the short and intermediate-term trends are now bearish, we want to reiterate our recent thoughts on the change of sentiment. Odds now favor Fibonacci retracements of 38.2% to 61.8% of the major indices' gains from their March lows to June highs. Projected downside targets of the "head and shoulders" patterns in the S&P and Dow hint at a 50% retracement off the highs. This is taken from our original analysis, in our July 1 commentary, when we said, "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." On the daily charts below, we've drawn Fibonacci retracement lines on the S&P, Dow, and Nasdaq, in order to give you an idea of where the next significant levels of price support may be found (moving averages have been removed for better visibility of the Fibonacci lines):







Presently, all of our open positions are inversely correlated "short ETFs" (UltraShort Real Estate [SRS], UltraShort Dow 30 [DXD], and UltraShort Oil & Gas [DUG]). Our position in UltraShort Financials (SKF) was closed for a quick gain of 9%, when it hit our short-term price target. If SKF breaks out above resistance of its June "swing high," active traders could re-enter it with a tight stop, in anticipation of making another leg up. A potential short entry into the S&P SPDR Retail (XRT) is also on our watchlist, as the ETF is poised to break down below a major level of price support. Still, despite the nice unrealized gains in our present positions, we're managing these bearish ETFs proactively because the main stock market indexes are likely to find substantial support between their 38.2% to 50% retracement levels. If our short ETFs have not hit our profit targets by that point, we'll trail stops much tighter, to lock in gains, and will simultaneously start looking for new buying opportunities on the long side of the market as new leadership develops. Obviously, the possibility of a drop all the way to the March 2009 lows is not entirely out of the question, but there's presently no technical reason to assume that will happen anytime soon. Overall, in the bigger picture, we continue to view the market's current correction as healthy. When the market pulls back during developing uptrends, it enables stocks to "catch their breath" and build bases of support from which to stage the next rally.

Open ETF positions:

Long - DXD, DUG, SRS
Short - (all three open 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.