Stocks got off to a positive start yesterday morning, as the S&P 500 rallied sharply and reclaimed its 50-day moving average by mid-day. But a negative, knee-jerk reaction to the afternoon Fed announcement on economic policy sparked a sell-off in the final hour of trading that caused the major indices to finish near the flat line and with mixed results. As expected by most analysts, the Federal Reserve Board left interest rates unchanged and gave no hint of an increase in the near future. Apparently taking this as a sign the economy is likely to remain weak for a while longer, traders sold into strength. The Dow Jones Industrial Average settled 0.3% higher and the S&P 500 eked out a gain of 0.1%. The Nasdaq Composite reversed an intraday gain of 1.2% into a closing loss of 0.3%. The Russell 2000 resumed its pattern of relative weakness, as the small-cap index shed 1.3%. The S&P Midcap 400 was lower by 0.5%. All the main stock market indexes finished near their lows of the day.

Total volume in the NYSE was 2% lighter than the previous day's level, while turnover in the Nasdaq edged 2% higher. In both exchanges, volume registered in the vicinity of 50-day average levels. In the NYSE and Nasdaq alike, market internals were nearly flat. Although the spread was firmly positive early in the session, declining volume finished fractionally greater than advancing volume.

Yesterday morning, the tug-of-war action in the broad market undoubtedly caused the S&P 500 to run stops of short sellers. The benchmark index gapped to open near its 50-day moving average, rallied to test its 20-day exponential moving average, then fell sharply into the close. Nevertheless, the S&P is now substantially above this week's low, so another test of those key moving averages in today's session would not be surprising. Below is the daily chart of S&P 500 SPDR (SPY):



On November 3, the Russell 2000 showed divergent relative strength by gaining 1.5%, versus an average gain of 0.3% in the S&P 500, Nasdaq, and Dow. This caught our attention as a potentially bullish development because the small-cap index has been showing so much relative weakness over the past month. However, the Russell failed to follow-up on Tuesday's bullish divergence, as the index resumed its pattern of relative weakness yesterday. As for its chart pattern, recall the Russell was the only one of the main stock market indexes that failed to rally above its September "swing high" last month, was the first index to break below its 50-day MA when the correction began, and is the only index already trading firmly below its early October "swing low." The daily chart of iShares Russell 2000 (IWM), a popular ETF proxy for the Russell 2000 Index, is shown below:



In the November 3 issue of The Wagner Daily, we suggested monitoring the Banking Index ($BKX) and Semiconductor Index ($SOX) as leading indicators for the respective directions of the S&P 500 and Nasdaq Composite. The relative performance of the Russell 2000 in the coming days should also serve as a leading indicator for the stock market. If the Russell starts waking up, meaning funds are starting to flow back into "riskier" small-cap securities, it could precede another broad-based rally attempt. Still, a resumption of strength in the U.S. dollar (UUP) could put a damper on any bull party.

The Fed said they don't plan to maintain exceptionally low interest rates for an extended period of time, but bond traders may be thinking differently. Despite the implication that interest rates will stay low, thereby aiding the price of treasury bonds, iShares 20+ year T-Bond (TLT) sold off to convincingly break support of an uptrend line that's been in place for nearly five months. Take a look:



Assuming the break of support was not a failed breakdown that snaps back above the trendline today, the outlook for our position in the inversely correlated UltraShort 20+ year T-bond (TBT) is now looking pretty good. Comparing the charts of TLT and TBT, there is not a direct inverse correlation, which is partially the result of the daily rebalancing of the TBT derivatives portfolio. But it's also because TBT does not get adjusted to trade at ex-dividend price every time TLT pays a dividend (usually monthly).

On a short-term basis, yesterday's session was pivotal for the stock market. If stocks manage to rally and close above yesterday's highs, we may see upside follow-through on the bullish, inverse head and shoulders patterns that have developed on numerous hourly charts. Conversely, a breakdown below yesterday's lows could quickly lead to a test of new lows for the week, which would also put the early October "swing lows" in jeopardy. While yesterday's late-session sell-off may have been scary for the bulls, it doesn't necessarily have the bearish implications one might expect. After important Fed meetings, the market's initial, "knee-jerk" reaction is often contrary to the real reaction that typically follows one to three days later. As such, we continue to lay low with regard to new trade entries, at least for the next few days.

Open ETF positions:

Long - UUP
Short - FAZ, EDZ, TBT (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.