Stocks sold off sharply last Friday, causing the broad market to snap its four-week winning streak. The major indices opened near the flat line, plunged in the morning, oscillated in a sideways range for several hours, then bounced off their worst levels of the day in the final thirty minutes of trading. Down 1.8% at its intraday low, the Dow Jones Industrial Averages finished 0.8% lower. The S&P 500 fell 0.9% and the Nasdaq Composite slid 1.2%. Small-caps suffered the worst, as the Russell 2000 tumbled 2.0%. The S&P Midcap 400 Index shed 1.4%. Thanks to a quick wave of buying interest leading up to the closing bell, the main stock market indexes settled near the middle of their intraday ranges.

Total volume in the NYSE swelled 41%, causing the S&P 500 to register a bearish "distribution day." However, that number may have been skewed by the previous day's temporary system outage in the exchange. Turnover in the Nasdaq was 8% below the previous day's level, enabling the tech-heavy index to avert the label of another session of institutional selling. Last Friday's higher volume loss in the NYSE means the S&P 500 has now had three "distribution days" in recent weeks. The count in the Nasdaq remains at three as well. As we've recently mentioned, a healthy market can normally absorb a few "distribution days" without consequence, but four or more days of institutional selling within a period of several weeks frequently leads to a significant correction in the market.

Despite last Friday's losses, the overall daily chart patterns of the major indices have not really changed. Stocks are still stuck in an indecisive, choppy range that has been in effect for the past several weeks. However, with the S&P and Nasdaq futures currently indicating a very weak start to today's session, that may soon change. Unless there is a substantial improvement leading up to Monday's open, the S&P, Nasdaq, and Dow are all poised to open approximately 2% lower than their last closing prices. Such action would put each of the major indices below the intraday lows of Friday's bearish session. More notably, the main stock market indexes will probably test short-term support of their 20-day exponential moving averages (EMAs), for the first time in more than a month. As it did on numerous occasions from March through May of 2009, the 20-day EMAs of the major indices may once again engage the bulls to spark a resumption of the uptrend that began with the March lows. On the daily charts of the S&P 500 and Dow Jones Industrial Average below, we've highlighted how the 20-day EMA (the beige line) neatly provided support during the March to May rally, at which point stocks entered into a four-week correction before resuming the previous uptrend:





Obviously, it's too early to tell whether or not the 20-day EMAs will provide the support they did during the stock market's last steady uptrend (March to May). But since this will be the first touch of the 20-day EMAs since the current uptrend began, more than four weeks ago, it would not surprise us if the bulls took advantage of today's opening weakness that's likely to run a lot of traders' protective stops. Nevertheless, when at obvious levels of support, such as the 20 or 50-day MAs, the main stock market indexes commonly "undercut" that support by 1 to 2% before stabilizing and reversing higher. This causes the "weak hands," who sell at the first hint of trouble, to dump their shares right into the waiting arms of the bulls who take advantage of prior levels of support. As such, even if the major indices close as much as 2% below their 20-day EMAs today, there will not yet be a confirmed break of support. On the other hand, if things get ugly and stocks slice through their 20-day EMAs in a big way, the selling could pick up considerable downside momentum in the short-term, as the next major levels of support are not until the 50-day moving averages (the teal lines on the charts above).

In the August 14 issue of The Wagner Daily, we looked at several potential breakout setups in ETFs including iShares Xinhua China 25 (FXI), Oil Service HOLDR (OIH), and Market Vectors Steel (SLX). If one were to ignore the technical levels of resistance (the breakout levels), and blindly buy those ETFs on last Friday's open, one would now be sitting on several losing trades. But the beauty of these trade setups, and most other "breakout" setups, is that no harm was done because they did not break out above resistance. Therefore, they failed to trigger our buy parameters. Since the broad market was stuck in a sideways range over the past few weeks, we wanted to be prepared with potential buy entries in the event of upside trend resolution in the major indices. However, with the stock market suddenly shifting to an apparent pullback mode, there may be more buying opportunities of ETFs pulling back to support of their 20 and 50-day moving averages, rather than breaking out above bases of consolidation.

After seeing how the major indices react on the first test of their 20-day EMAs today, we'll take a freshly updated look at potentially attractive ETF trade setups that grab our attention over the next few days. It's still a bit too early to consider the short side of the market for anything more than a very short-term trade, but we certainly won't rule out that possibility either, especially if stocks happen to below through their 20-day EMAs in a big way. If they do, we may look for ETFs with relative weakness to sell short on the first bounce into resistance. Either way, we'll keep you informed of our technical take on the stock market, and whether the developing correction is a buying opportunity, or the time to become a bear.

Open ETF positions:

Long - IBB, SMH, DGP, DBO, FXB
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.