Opening above the highs of their recent consolidation patterns, stocks broke out above their short-term trading ranges yesterday morning, but a late-day reversal caused the major indices to surrender a majority of their intraday gains. The S&P 500 gained 1.2% and the Dow Jones Industrial Average climbed 0.9%. The Nasdaq Composite finished 0.8% higher, though the index was trading 2.1% higher at its best level of the day. Small and mid-cap stocks turned in the best performance. The Russell 2000 climbed 1.7%, as the S&P Midcap 400 Index advanced 1.3%. The S&P 500 and Dow Jones Industrials closed near the middle of their intraday ranges. For the first time in weeks, the Nasdaq settled near the day's low.

Turnover surged 19% across the board, technically causing the S&P 500 and Nasdaq Composite to register a bullish "accumulation day" by gaining on higher volume. But given the late-day selling and weak closing prices of the major indices, mutual funds, hedge funds, and other institutions were apparently selling into strength as well. Turnover in both exchanges moved back above average levels, which wasn't surprising considering many traders and investors were waiting on the sidelines until the market made a move out of its preceding range. Market internals started the day quite positive, but deteriorated as the day progressed. By the closing bell, advancing volume exceeded declining volume, in both exchanges, by approximately 2 to 1.

We enter the last day of a very bullish month with the stock market at a rather interesting juncture. Coming into this week, many traders (including us) were looking for the major indices to pull back slightly, which would have provided a multitude of buying opportunities in strongly trending ETFs. Instead, stocks entered into a "correction by time," consolidating in a tight, sideways range near the highs. Then, yesterday, the broad market gapped above the highs of its recent consolidation, on higher than average volume. Initially, this appeared to be a bullish continuation of the dominant uptrend, but institutions sold into strength of the move, causing the main stock market indexes to close near their intraday lows and form bearish "shooting star" candlestick patterns on their daily charts. This puts the major indices in danger of failing yesterday's breakout attempt. We've highlighted the "shooting star" pattern on the daily chart of the Dow Jones DIAMONDS (DIA), a popular ETF proxy for the Dow Jones Industrial Average:



Over the past few days, we've been saying the market has been "a bit confused and nervous." As such, yesterday's strength on the open, followed by weakness in the afternoon, was not very shocking to us. It was merely the reverse of the intraday price pattern we've been seeing, where stocks have started the day showing weakness, only to recover into the close. Still, one key difference between yesterday's intraday trend reversal, and other intraday reversals of the past week, is that yesterday's tug-of-war between the bulls and bears occurred as the major indices should have been showing strength after the opening breakout. On a technical level, the breakout had no significant overhead resistance levels to contend with, but it fizzled out regardless.

In yesterday's Wagner Daily, we discussed the increasing possibility of the major indices breaking out above the highs of their recent trading ranges, without pulling back first. If that happened, we said we would "go with the flow" and selectively enter a few new long positions. However, we also cautioned that, "the only caveat is that any new entries we take will have tight stops, just below their breakout levels. This will help to protect against the possibility of 'fakeout breakouts.' When buying a breakout above a tight base of consolidation, we've found that tight stops are most effective in protecting against the vicious downside momentum that frequently occurs from failed breakouts." When stocks gapped up yesterday morning, we followed our plan and entered two new long positions (TAN and INP), but subsequent weakness in the broad market prompted us to make a judgment call to sell our positions for a scratch, rather than risking getting long just as the broad market potentially fails a breakout attempt. The problem with breakouts above obvious levels of resistance in the major indices is they have a high rate of failure; institutions frequently use the liquidity boost of the breakout as a chance to sell into strength.

Yesterday's price action leaves us with a situation where many ETFs have just broken out above resistance levels, but are now in immediate danger of failing their breakouts. Such action could lead to a substantial downside correction if those ETFs quickly fall back into the previous ranges they just broke out above. Nevertheless, unless the major indices fall below the lows of their recent trading ranges, quite a bit below current levels, short positions are not very attractive. Conversely, new long entries after yesterday's weak close could be dangerous as well. Therefore, our current overall plan consists of two low-risk strategies:

The first strategy is to focus new ETF entries with a low correlation to the direction of the overall stock market. This would include various currency or commodity-based ETFs, of which we're already positioned in one of each. The second strategy is to build and maintain a watchlist of strong ETFs to buy if they retrace to key support levels such as their 20 or 50-day moving averages. Below are two charts of ETFs with low correlation that may be buyable in the near-term:



We began discussing FXB as a potential buy entry last week, but it apparently was not yet ready to go. However, with the 10-week moving average rising up to provide support, and the trading range tightening up over the past two weeks, FXB now looks even more attractive for breaking out of its base. We like it for buy entry above the $166.50 area. Next, take a look at the daily chart of U.S. Oil Fund (USO), which is roughly correlated to the price of the crude oil commodity futures:



Because of its close proximity to pivotal moving averages, such as the 20-, 50-, and 200-day moving averages, USO has been very choppy and indecisive over the past week. Yet, if USO rallies above the July 27 high of $36.48, bullish momentum could send USO substantially higher, above the June 2009 high, in the short-term. This is primarily because it would lead to a breakout above the 200-day moving average for the first time in nearly a year. Convergence of the 20, 50, and 200-day moving averages, just below that breakout level, would provide solid support in the event of a subsequent pullback.

Open ETF positions:

Long - DGP, FXY
Short - (none)

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.