Initially brushing off the previous day's weakness, stocks raced higher out of the starting gate yesterday morning, but the bears resumed control less than an hour later, sending the major indices sharply lower. Aided by continued strength in online retail giant Amazon.com, the Nasdaq Composite was trading 1.3% higher after the first thirty minutes of trading. However, an intraday slide of nearly 2%, which began in the late morning and persisted throughout the afternoon, left the tech-heavy index with a closing loss of 0.6%. The S&P 500 and Dow Jones Industrial Average followed similar intraday patterns and lost 1.2% and 1.1% respectively. Small and mid-cap stocks were in lockstep with their large-cap brethren, as the Russell 2000 fell 1.2% and the S&P Midcap 400 declined 1.1%. Each of the main stock market indexes closed near its lowest level of the day.

Total volume in the NYSE ticked 9% higher, while turnover in the Nasdaq was 4% lighter than the previous day's level. The mixed volume levels caused the S&P 500 to suffer another bearish "distribution day," as the Nasdaq averted the same negative label. A closer look at the intraday volume pattern of the NYSE also confirmed the bearishness. One hour after the open, when stocks were still trading near their best levels of the day, volume in the NYSE was tracking 16% lighter than the previous day's level. But the pace of trading heated up when stocks began selling off shortly thereafter. This is the opposite of bullish price action, in which volume would be heavier on the way up, and lighter on the way down. The higher volume loss in the NYSE tells us mutual funds, hedge funds, and other institutions were leading the selling.

In the October 22 issue of The Wagner Daily, we analyzed the sudden, late-day sell-off that hit the broad market the previous afternoon. The conclusion was it was sparked by a swift drop in the financial sector, particularly Wells Fargo and Bank of America. At the time, we said, "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." The following day (October 22), financials snapped back, but a wave of selling again plagued the sector yesterday. In fact, the extreme relative weakness in banking shares was apparently one of the factors that subsequently caused the market to fall apart late yesterday morning.

After the first fifteen minutes of trading, the KBW Bank Index ($BKX) was already trading 1.6% lower, even as the S&P 500 had moved to a 0.4% gain. When the broad market moved to its morning high, about thirty minutes after the open, the $BKX was still showing a loss of nearly 1%. The obvious bearish divergence in the banking sector caused us to believe the morning strength was unsustainable. It also prompted us to send an Intraday Trade Alert to subscribers, saying we were swapping our position in UltraShort Real Estate ProShares (SRS) for a new position in Financial Bear 3X (FAZ), as the banking stocks were showing much more relative weakness than the financial-related real estate sector. By the closing bell, the $BKX index had tumbled to a 4.1% loss, and the inversely correlated FAZ had rallied to a 6.8% gain. The "percentage change chart" below shows yesterday's relative weakness in the banking sector, which weighed heavily on the market yesterday:



More important than just yesterday's weakness of the financials is that many of the related ETFs closed below key support of their 50-day moving averages, as shown below:







Another factor that probably sparked yesterday's sharp, late-morning reversal was a rare show of strength in the U.S. dollar. As the dollar suddenly began showing convincing strength against many currencies, commodities such as oil and metals began selling off, further weighing on the stock market. Volume in the U.S. Dollar Bull Index (UUP) surged to more than three times its average daily level, indicating the presence of institutional accumulation as well. Taking a look at the daily chart of UUP, notice it is rallying to breakout above its 20-day EMA, as well as a six-month downtrend line. Strong volume near the lows is helping to confirm the move:



Looking at the longer-term weekly chart of UUP, one sees it has come into a major area of support. Its prior lows from mid-2008 are a likely factor for the sudden show of strength:



As the dollar rallied, treasury bonds sold off, causing our position in UltraShort 20+ year T-bond (TBT) to jump more than 2% yesterday. TBT has now definitively broken out above its four-month downtrend line and 50-day MA:



Yesterday after the close, Baidu, a Nasdaq-leading stock, reported their latest quarterly earnings. Due to a lowered outlook moving forward, the stock immediately plunged in the after-hours market, and was last seen trading approximately 15% lower. Keep an eye on Baidu (BIDU) today, as it could weigh on the direction of the Nasdaq. In the S&P and Dow, the financials are probably the sector to watch as a leading indicator for intraday price action. The major indices have broken below last week's lows, and are testing support of their 20-day EMAs. If yesterday's lows fail to hold, be prepared for the possibility of substantial downside momentum.

Open ETF positions:

Long - TBT, USO, SEA, UNG
Short - FAZ (an inversely correlated ETF 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.