Following through on the previous day's stumble, bearish momentum picked up substantially yesterday, causing all the major indices to suffer losses of at least 2%. An upward surge in the first forty-five minutes of trading encouraged the bulls, but the bears aggressively sold into strength of the bounce, causing stocks to plummet into mid-day. Throughout the afternoon, the main stock market indexes consolidated in a holding pattern, before making a test of new intraday lows into the close. The Nasdaq Composite and Dow Jones Industrial Average lost 2.0%, while the S&P 500 tumbled 2.2%. The small-cap Russell 2000 slid 2.5%, as the S&P Midcap 400 shed 2.2%. All the major indices closed at their lows of the day, thereby putting pressure on today's open.

Turnover surged across the board, as institutional investors headed for the exit doors. Total volume in the NYSE raced 19% above the previous day's level, while volume in the Nasdaq swelled 23%. The S&P 500's loss on higher volume caused the index to register its second straight "distribution day." In the Nasdaq, yesterday's distribution followed the bearish "churning" that occurred on August 28. Market internals were quite ugly. In the NYSE, declining volume trounced advancing volume by a margin of 15 to 1. The Nasdaq adv/dec volume ratio was negative by nearly 7 to 1.

In the August 28 issue of The Wagner Daily, we warned that the sudden display of relative weakness in the Chinese market, as well as other emerging markets, could be a "reliable warning signal that a correction in the U.S. broad market is forthcoming." The next day, the Shanghai Composite plunged 6.7%, causing the S&P, Dow, and Nasdaq to lose approximately 3% over the following two days. Because Chinese stocks and ETFs were among the best performers while the U.S. market was going up, we expected a sudden change of sentiment in China to have bearish implications for the U.S. markets as well. Since that's what appears to be happening right now, subscribers to this newsletter should not have been shocked by the market's losses of the past two days.

Yesterday morning, bulls made a valiant attempt to reverse the previous day's losses. After opening slightly lower, stocks immediately reversed higher. Less than an hour after the open, the Nasdaq Composite had erased the previous day's loss, and was showing a gain of 1.2%. At the same time, the S&P 500 was similarly trading 0.8% higher. But one major problem with the opening strength was the clear display of relative weakness in the financial sector. While the broad market was at its intraday high, banking, insurance, and real estate ETFs were all trading near unchanged levels. Since financials were one of the strongest sectors during the market's recent uptrend, we viewed the financials' lack of participation in the morning rally to be a significant event, and a warning sign that the market's early strength would be unlikely to last. Our assessment prompted us to quickly scan the patterns of various financial ETFs, in search of a possible short entry, in the event of a major reversal lower. Upon doing so, we determined the basing pattern of UltraShort Real Estate (SRS), an inversely correlated ETF, could be worthy of potential buy entry, in anticipation of a short-term trend reversal. As such, we sent an Intraday Trade Alert to subscribers, warning them of weakness in the financial sector, and informing them of our trade setup in SRS. The hourly chart of SRS below illustrates our buy entry:



On the daily chart below, notice yesterday's rally caused SRS to break out above resistance of a downtrend line that has been in place for nearly two months:



A rally above its 20-day EMA (the beige line), within pennies of its current price, should confirm the bullish, short-term trend reversal (which is conversely bearish for the real estate sector). Our approximate price target is resistance of the 50-day MA (the teal line), presently at $16.15, and just below resistance of the June 2009 lows. Our protective stop is now just below yesterday's low, therefore giving us an extremely positive reward-risk ratio on the trade. Traders looking to take advantage of the sudden weakness in financials might also consider buying UltraShort Financials ProShares (SKF), which has a similar pattern to SRS. However, as with many of the leveraged ETFs, remember they're best-suited for only short to intermediate-term speculative purposes; many of them underperform their underlying indexes in the long-term. Rather than buying the inversely correlated ETFs, one might consider selling short iShares Real Estate (IYR), S&P Financial SPDR (XLF), Regional Banks HOLDR (RKH), or SPDR Insurance (KIE).

When the main stock market indexes broke out to new highs of the year, on August 21, we discussed the basic technical reasons why we felt the breakout had a significant chance of failing to hold. Now, after one week of choppy deliberation, the breakout indeed seems to have failed. In addition to falling below support of their breakout levels, all the major indices also closed below their 20-day EMAs yesterday. If they fail to recover back above their 20-day EMAs within the next one to two days, we will likely see another leg down in the broad market. Key support of the 50-day MAs, right in the vicinity of the June 2009 highs, may be a realistic, short-term target for the major indices.

Open ETF positions:

Long - DGP, VXX, IBB
Short - FXI, TWM, SRS (TWM and SRS are inversely correlated ETFs we're long)

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.