The pre-market weakness discussed in yesterday's commentary followed through in the regular session, causing the broad market to break below the lows of its indecisive, multi-week trading range. All the major indices fell at least 2%, and also tested support of their 20-day exponential moving averages (EMAs). The Dow Jones Industrial Average plummeted 2.0% and the S&P 500 shed 2.4%. The Nasdaq Composite, small-cap Russell 2000 and S&P Midcap 400 indices all suffered identical losses of 2.8%. Although each of the main stock market indexes closed near its intraday low, most of yesterday's losses were the result of an opening gap down in the broad market. Thereafter, stocks merely traded in a tight, sideways range throughout the rest of the day.

Total volume in the NYSE rose 12% above the previous day's level, while volume in the Nasdaq eased 1%. The higher volume decline in the NYSE means the S&P 500 suffered its fifth day of institutional selling in recent weeks, a signal the stock market is in a legitimate correction mode. However, slightly lighter turnover in the Nasdaq enabled the exchange to avert the bearish label of another "distribution day." Atrocious market internals confirmed the broad-based selling. In the NYSE, declining volume trounced advancing volume by approximately 15 to 1. The Nasdaq adv/dec volume ratio was negative by a ratio of more than 11 to 1.

In yesterday's Wagner Daily, we discussed how the major indices were poised to test short-term support of their 20-day EMAs. More specifically, we said, "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." Not surprisingly, the main stock market indexes indeed closed below their 20-day EMAs, but only by a small margin. The S&P is only 0.5% below its 20-day EMA and the Nasdaq 1.5%. The Dow settled less than 0.1% below its 20-day EMA.

With the S&P 500 registering its fifth day of higher volume losses in recent weeks, leading individual stocks sagging, and the major indices deliberating near their 20-day EMAs, new buy entries are probably best avoided right now. When the market is under distribution, breakouts above consolidation have a higher risk of failure, and even pullbacks to support often retrace steeper than one might expect. As such, we're primarily focused on managing existing open positions right now, rather than entering new ones.

While most international ETFs are still holding up well, iShares Xinhua China 25 (FXI) broke down to close below key support of its 50-day MA yesterday. There have been several intraday tests of the 50-day MA since its uptrend began in March of 2009, but yesterday was the first time since then that FXI has actually closed below its 50-day MA. Though it may be premature to say the rally in Chinese shares is dead, there definitely appears to be a sudden shift of sentiment. If FXI fails to snap back above its 50-day MA within the next few days, it could have negative implications for other emerging markets ETFs as well:



One likely pattern FXI may form in the coming days is a "bear flag," which would occur if the ETF gradually wedges higher off of yesterday's lows, but fails to garner upside momentum. We'll be looking for such a formation to develop, as it would present a low-risk short selling opportunity, our first possible re-entry into the short side of the market since the mid-June to mid-July correction. A downward move to its July 2009 lows, around the $36 level, could be a realistic near-term price target if we get a decent "bear flag" entry sometime this week. For those who prefer the inversely correlated ETFs, UltraShort Xinhua ProShares (FXP) is the one to check out. However, as with many "leveraged" ETFs, be aware that FXP has slightly underperformed its corresponding index over the long-term, so it's best viewed as a short-term trading vehicle.

Another emerging market ETF we'll be keeping an eye on this week is iPath India Index (INP), a recent leader of the international ETFs that may also be seeing a changing of the guard. On the daily chart below, notice the early August breakout attempt in INP failed, thereby causing a potential "double top" to form on its daily chart. Then, as with FXI, INP gapped down to close below its 50-day MA yesterday:



Obviously, one cannot rule out the possibility of the market blowing off yesterday's losses and swiftly re-bounding. However, one difference between yesterday's test of the 20-day EMAs of the major indices, and those tests of support that successfully held up from March through May of 2009, is the negative volume patterns that are accompanying this market correction. Other touches of the 20-day EMAs, shortly after the rally began, were not faced with five days of distribution in the S&P and four in the Nasdaq. After a few more days of trading, the charts will give us a much better idea of whether or not the current pullback off the highs is likely to be short-lived. If so, we'll consider new buy entries in recent breakouts that have pulled back, such as iShares Real Estate (IYR) or S&P Financial SPDR (XLF). Otherwise, we'll target short selling entries in select ETFs that break down below major support, then bounce into resistance of the breakdown level. For now, it's a good idea to stay on the sidelines and let the market's price action determine our next move.

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.