Bouncing back from its recent decline and four straight days of losses, the stock market surged higher yesterday, enabling the S&P and Nasdaq to reclaim their 50-day moving averages. The session was virtually a mirror image of the previous day's action, as the major indices opened higher, then trended steadily north throughout the entire day. The Nasdaq Composite rallied 1.8%, the Dow Jones Industrial Average 2.1%, and the S&P 500 2.3%. The small-cap Russell 2000 jumped 2.4% and the S&P Midcap 400 gained 2.2%, but both indexes only recovered about two-thirds of Wednesday's losses, and also remained below their 50-day lines. Whereas all the main stock market indexes tumbled to close at their intraday lows on Wednesday, each zoomed to finish near its best level of the day in yesterday's session.

It's positive that stocks were able to erase most to all of the previous day's decline, but one crucial element lacking from the rally was higher volume. Total volume in the NYSE declined 14%, while volume in the Nasdaq receded 16%. Turnover in the Nasdaq even finished slightly below its 50-day average level. If higher volume would have accompanied yesterday's gains, the broad-based rally would have been much more convincing. However, the significantly slower pace of trading tells us institutions were nervous and not convinced about aggressively buying shares. Since more than half of the stock market's average daily volume is the result of institutional trading, this is an important observation. When a market makes a large percentage move in one direction, then follows with an equally large move in the opposite direction, a look "under the hood" at volume patterns and market internals is a legitimate way to determine whether the bulls or bears had the upper hand. In this case, we have to say the bears still have the upper hand this week. As mentioned in yesterday's commentary, it may be dangerous to start buying back into the market until we see a solid "accumulation day," backed by institutional rotation back into the market.

In the October 27 issue of The Wagner Daily, we pointed out the potentially bullish developments taking place on the daily and weekly charts of the U.S. Dollar Bull Index (UUP). Now, three days later, UUP has broken out and pulled back, providing for an ideal entry point on the long side. The setup is illustrated on the daily chart of UUP below:



The most important element of the chart above is that UUP just broke out above resistance of a six-month downtrend line AND did so on a strong volume surge. From October 26 to 28, while UUP was breaking out, volume spiked to approximately three times its average daily volume on each of those days. This tells us substantial institutional accumulation coincided with that break of the downtrend line off the April 2009 high. Then, UUP neatly pulled back to new support of that downtrend line yesterday (remember that a prior level of resistance becomes the new level of support after the resistance is broken). On the longer-term weekly chart of UUP below, notice this week's volume has been massive, the most shares of UUP that has ever exchanged hands in a one-week interval (with another day remaining too):



With support of both its prior downtrend line and 20-day EMA just below yesterday's low, UUP now makes for a compelling buy entry with a positive reward-risk ratio. As such, we sent an Intraday Trade Alert to subscribers yesterday afternoon, informing of details for our new long entry into UUP. Though resistance of its 50-day MA is still overhead, our entry point into UUP is low enough that the trade can still be scratched, or closed with a small profit, if UUP stalls after running into the 50-day line. But frankly, a break of a six-month downtrend line on huge volume probably holds more weight than a 50-day MA.

In addition to the actual play of buying the ETF, there are two other important implications to be aware of if UUP follows through with a bullish reversal from here. One is that a stronger dollar usually, but not always, weighs on the various commodities. For that reason, we made a judgment call to sell and lock in profits on our U.S. Oil Fund (USO) position today, despite the fact it has been acting pretty well since its mid-October breakout above horizontal price resistance. Traders who presently have other commodity-related positions may want to start closely monitoring UUP.

The second, more significant, implication of strength in the U.S. dollar is that it may pressure the overall stock market. We've been watching the performance of UUP closely this week, and have noticed that virtually every intraday rally in UUP has coincided with a simultaneous decline in the broad market (and vice versa). This is best illustrated on the chart below, which clearly illustrates the relative price performance and intraday trends of the S&P 500 SPDR (SPY) versus UUP so far this week:



In yesterday's commentary, we said, "In both the NYSE and Nasdaq, declining volume beat advancing volume by a margin of more than 9 to 1. When such an overly bearish adv/dec volume ratio occurs after a string of losing sessions, it often precedes at least a modest one or two-day bounce in the markets. Therefore, odds are pretty decent that we see a little buying interest today or tomorrow, especially considering many traders will be speculating on the possibility of the major indices snapping back above their 50-day MAs. Nevertheless, we caution against blindly entering new swing trades on the long side of the market right now. In order to do so, we would first want to see some type of bullish confirmation, such as a day or two of high volume gains and/or sudden strength among leading stocks." That anticipated bounce indeed came yesterday, but our advice remains the same going into today. Continue with extreme caution on the long side until the stock market shows us some type of convincing, bullish confirmation. Broken down or trend-reversing ETFs bouncing into resistance may present new short selling opportunities, though it's still too early to heavily get short.

Open ETF positions:

Long - UUP
Short - FAZ, TBT, EDZ (all three are inversely correlated "short 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.