Taking advantage of the previous day's bounce, traders aggressively sold into strength last Friday, causing the major indices to surrender all of Thursday's gains and break down to new lows of the week. Stocks opened near the flat line, but subsequently trended steadily lower throughout the day. Both the Nasdaq Composite and Dow Jones Industrial Average fell 2.5%, as the S&P 500 plunged 2.8%. The small-cap Russell 2000 and S&P Midcap 400 indices shed 3.0% and 2.8% respectively. All the main stock market indexes closed at their worst levels of the day and week. For the month of October, the stock market's losses were relatively modest, but the final week of the month was nasty. Last week, the Dow declined 2.6%, the S&P 4.0%, and the Nasdaq 5.1%.

For most of the day, volume was tracking below the previous day's levels, but turnover picked up in the final hour of trading. Total volume in the NYSE finished 13% above the previous day's level, while volume in the Nasdaq ticked 10% higher. When stocks bounced back with large percentage gains last Thursday, the light volume that accompanied the rally prompted us to warn against getting back on the long side of the market. The warning generated from the bearish price to volume relationship proved to be right. Last Friday's sharp losses on higher volume tells us mutual funds, hedge funds, and other institutions were distributing shares again, just as we've seen numerous times in recent weeks. However, with the market now firmly in correction mode, the "distribution day" count becomes largely insignificant; rather, we're now on the lookout for convincing displays of institutional buying that would precede a near-term bottom.

The CBOE Volatility Index ($VIX), a popular measure of the implied volatility of S&P 500 index options, has broken out above a substantial level of horizontal price resistance to close at its highest level since early July of this year. The $VIX is commonly referred to as the "fear index" because it represents the market's expectation of volatility over the next 30-day period. The daily chart of the $VIX is shown below:



As technical analysis goes, we typically focus on basics such as relative strength, trendlines, moving averages, and volume patterns to guide our trading and investment decisions. When looking at the $VIX, we generally view it as a way to confirm other trends we're seeing on the charts. In this case, the $VIX appears to be confirming the sudden change of market sentiment over the past few days. By the way, while on the subject, we'd like to make you aware there is indeed an ETF that supposably tracks the movement of the $VIX, but we do not recommend trading it for anything more than an intraday trade. This is because the ETF has consistently lagged the actual $VIX by such a wide margin that there seems to only a minimal correlation. Just for kicks, take a look at the daily chart of iPath S&P 500 VIX Short-Term (VXX):



While the actual $VIX Index has broken out to close at its highest level since July, VXX has yet to even break out above its prior high from October. In fact, VXX is still trading below its 50-day moving averages; whereas, the $VIX index is well above its 50-day MA, and is about to test its 200-day MA. We'll spare you the gory details of why its portfolio composition causes VXX to lag the $VIX so badly, but suffice it to say you have been cordially warned.

Each of the main stock market indexes closed below its 50-day moving average last week, indicating a potential reversal of intermediate-term trend. For now, the charts have only confirmed the presence of short-term downtrends, but the intermediate-term uptrends of the major indices would reverse with the formation of significant "lower lows" on their daily charts. This would occur if stocks break down below critical support of their late September/early October lows. On the daily charts of the S&P 500 and Dow Jones Industrial Average below, the dashed, horizontal lines mark pivotal support of those prior lows:





Presently, the S&P and Dow are above their October 2 lows by 1.5% and 2.9% respectively. With the Dow only barely closing below its 50-day moving average last week, the blue-chip index is showing more relative strength than the broad-based S&P. The Dow is also above its October low by approximately double the range of the S&P. However, it's notable that the tech-heavy Nasdaq Composite is already testing crucial support of its October low. Take a look:



Although it's difficult to see on the chart above, the Nasdaq technically closed the week three points below its October 2 closing low, but is still about five points above the intraday low of October 2. Obviously, a closing break of support by such a narrow margin is not convincing, as indexes commonly "undercut" key support levels by as much as 2 to 3% before reversing higher. Nevertheless, keep a close eye on the performance of the Nasdaq this week. Though the S&P and Dow are still firmly above their October lows, a breakdown to a "lower low" in the Nasdaq could cause the S&P and Dow to follow suit very rapidly. We continue to avoid new buy entries in the market-correlated ETFs until we see some bullish signs.

Open ETF positions:

Long - UUP
Short - TBT, FAZ, 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.