A solid start led to an ugly finish yesterday, as a late-day sell-off sparked substantial losses across the board. After trending higher throughout the morning session, stocks initially erased Tuesday's losses and were back to testing their recent highs. Thereafter, the main stock market indexes merely drifted sideways to lower throughout most of the afternoon, but a fast and furious selling spree into the close wreaked broad-based havoc. The Nasdaq Composite lost 0.6%, as both the S&P 500 and Nasdaq Composite fell 0.9%. Each of three indexes suffered an intraday plunge of approximately 1.5% in just the last forty-five minutes of trading. The small-cap Russell 2000 and S&P Midcap 400 indices shed 1.4% and 1.1% respectively. All the major indices finished at their lowest levels of the day.

Turnover swelled in both exchanges yesterday, causing the S&P and Nasdaq to register yet another "distribution day." In the NYSE, total volume increased 14% above the previous day's level, while volume in the Nasdaq surged 21% higher. NYSE and Nasdaq volume also moved back above 50-day average levels, indicating the presence of significant selling amongst mutual funds, hedge funds, and other institutions. After the higher volume losses of October 20, we said, "The broad-based losses on increasing volume caused the S&P 500 to suffer its seventh "distribution day" in recent weeks. The Nasdaq registered its fourth day of institutional selling within the same period. A healthy market can typically absorb a few days of higher volume losses over a three to four week period, but five or more "distribution days" often overpowers the buyers, leading to a significant correction in the market. Since yesterday marked the seventh day of institutional selling in the S&P within the past month, astute traders will use caution on the long side of the market right now." Indeed, respecting the early warning signals of the stock market's recent distribution days kept us out of harm's way yesterday. Since volume is the footprint of institutional trading activity, it is one of the few technical indicators that never lies.

In addition to the stock market's recent pattern of lighter volume gains and heavier volume losses, there were several other warning signs we've been discussing in recent issues. One was the inability of the Russell 2000 to follow the S&P, Nasdaq, and Dow by breaking out to a fresh 2009 high last week. Another concern was major overhead resistance of the long-term, two-year downtrend lines on the S&P and Dow, just a few percent above current prices. Even the popular financial media's fanfare and hype of the Dow closing above 10,000 (on October 14) was a sign to use caution on the long side of the market. In our October 15 commentary, we said, "Ironically, and somewhat humorously, one popular financial news outlet was implying that the Dow's crossing of the 10,000 level was a good reason for the general public to now start jumping back in the market. Ha! Where was that advice 6 months ago? If only the average investor were to glance at a long-term chart of the S&P or Dow, he/she would not start buying, right as the stock market approaches huge long-term resistance levels." Anyway, all of these warning signals may finally be coming to fruition in the form of an impending stock market correction of significance.

Yesterday's late day collapse apparently started in the financial sector, and quickly spread to most other industries as well. The S&P Financial SPDR (XLF), a popular ETF proxy for the overall financial sector, swiftly nosedived 2.8% in the last fifty minutes of trading. The late-day slide is shown on the 15-minute intraday chart of XLF below:



Blame it on Bank of America. Four days ago, the well-known bank fell nearly 5% after announcing an earnings report that fell short of expectations. The decline in Bank of America (BAC) had a broad-reaching effect within the financial sector, which has been showing relative weakness since then. At mid-day yesterday, BAC lost support of its three-day low, which coincided with key support of its 50-day moving average. Several hours later, the rest of the banking sector came crashing down, triggered by an intraday downgrade of Wells Fargo, as well as the breakdown in BAC.

It's significant that yesterday's sell-off was led by the financial sector because it was financials that initially kicked off the March 2009 rally, then kept it going as well. Because they're so heavily weighted in the stock market, it could have negative implications for the longer-term health of the overall market If financials start reversing back down in a meaningful way. Since the rally off the March 2009 lows began, BAC has held support of its 50-day moving average the entire time. Prior to now, there was only one instance where BAC dipped below its 50-day MA, at the beginning of this month, but it snapped back above it two days later. However, BAC broke support of its 50-day MA in a convincing way yesterday, as it currently resides 3.9% below it. A violation of more than 3 to 4% below a key level of support typically confirms the break of technical support, whereas a probe of just 1 or 2% below a level of support is known as an "undercut" (which is often bullish).

Not surprisingly, the weakness in financials caused our setup in UltraShort Real Estate ProShares (SRS) to trigger for buy entry. As thoroughly explained in yesterday's commentary, we're scaling into this trend reversal setup with two separate entry points. So far, only the first half of the trade triggered for entry. Obviously, one might also consider selling short XLF on a bounce, or simply buying UltraShort Financials ProShares (SKF) (on a pullback) for a near-term momentum trade (at least for now). As for the other positions in our portfolio, we're pleased that all but one of the ETFs is commodity-related, and therefore has a low correlation to the overall direction of the stock market. While most stocks and ETFs suffered losses yesterday, our positions in U.S. Oil Fund (USO) and PowerShares Base Metals (DBB) both gained more than 2.5%. The iShares Silver Trust (SLV) advanced 1.0%.

Open ETF positions:

Long - DBB, USO, SLV (half position), UNG, SEA
Short - SRS (an inversely correlated ETF we're long - just half position for now)

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.