Breaking out of their short-term trading ranges that began last week, the major indices leapt to an impressive round of gains yesterday. This time, higher volume even accompanied the move. Stocks opened with substantial gains, trended sideways to higher throughout most of the day, then retraced a bit of the intraday advance in the final hour of trading. Still, the S&P 500 climbed 1.5%, the Nasdaq Composite 1.4%, and the Dow Jones Industrial Average 1.3%. All three indexes closed at fresh highs of the year. Small and mid-cap stocks remain below their "swing highs" from October, but showed relative strength yesterday. The Russell 2000 and S&P Midcap 400 indices rallied 2.8% and 1.8% respectively. The late-day pullback, apparently triggered by interesting bearish comments from Meredith Whitney, prevented the main stock market indexes from finishing at their best levels of the day, but they still settled around the upper quarter of their intraday ranges.

Total volume in the NYSE increased 16% above the previous day's level, while volume in the Nasdaq ticked 12% higher. The broad-based gains on higher turnover caused both the S&P and Nasdaq to register a bullish "accumulation day" for only the second time this month. Trading in both exchanges still remained below 50-day average levels, but at least there signs of institutional buying for a change. Market internals were very solid, indicating the buying was broad-based across most industry sectors. In the NYSE, advancing volume exceeded declining volume by a margin of 7 to 1. The Nasdaq adv/dec volume ratio was positive by 4 to 1.

Several times over the past month, we mentioned the S&P 500 was approaching major resistance of its weekly downtrend line, which began with the October 2007 high. Because of yesterday's rally, the index is now faced with a test of that pivotal indicator of long-term trend. The downtrend line is illustrated on the weekly chart of the S&P 500 below: Note this chart is linear-scaled; on a semi-log chart, the downtrend line is still about 40 points above yesterday's close (but still near nonetheless):



The blue-chip Dow Jones Industrial Average has also rallied enough to kiss its long-term downtrend line with just another day or two of gains:



In addition to its downtrend line, the S&P 500 is also just 1% below resistance of its 50% Fibonacci retracement from the October 2007 high to the March 2009 low:



Although the combination of the weekly downtrend line and 50% retracement level of the S&P will likely provide formidable resistance in the near-term, we are NOT suggesting the charts above are a good reason to suddenly start selling short into the face of yesterday's breakout. With pivotal levels of resistance such as the two shown above, indexes frequently probe beyond the obvious levels of resistance before reversing back down (an "overcut"). As such, the S&P could easily move up to 3 - 5% higher before feeling the effect of its downtrend line and 50% Fibonacci retracement level.

Because these charts are of a longer-term timeframe, they are not meant to provide actionable trade ideas right now. Rather, the principal purpose of this analysis is to remind subscribers that the broad market technically remains in a long-term downtrend, which has been in place for a little more than two years. The rally off the March 2009 lows has been incredible so far, but so was the sell-off that preceded it. In the "bit picture," one can still successfully argue the rally of the past eight months is merely a (rather large) bear market bounce. Of course, if the S&P and Dow blow through their weekly downtrend lines and Fibonacci resistance levels, we would be forced to change that assessment.

After closing a losing trade, do you ever find yourself wondering if you were wrong to enter the trade in the first place, or if the trade setup was good, but simply did not work out? If so, the answer to that question can be found by asking yourself the question of. . ."Knowing what I now know, in hindsight, would I still have entered the trade exactly the same way, given the opportunity?" If the answer to that question is "yes," then you were probably not wrong to enter the trade. The trade simply ended up on the losing side of standard deviation. We view our recent short entry into the inversely correlated UltraShort Russell 2000 (TWM), which hit our stop yesterday, as one such example.

Last week, on November 12, we sold short the Russell 2000 Index (through buying TWM). The entry was made after the laggard index, which recently formed a "lower low" below its early October low, rallied into and stalled at resistance of its 50-day moving average. Thereafter, the trade briefly showed a small profit, but yesterday's broad market rally caused the Russell 2000 to reverse and break out above key resistance of its 50-day MA. Since we set our initial stop just above the 50-day MA (plus some "wiggle room" to withstand a possible "stop hunt"), the trade hit our stop price yesterday. Nevertheless, despite the loss, we would still take the exact same trade again, if given the opportunity. Furthermore, because it was a short position, we intentionally cut our initial capital risk in half by limiting share size on the initial entry to just 50% of our normal position size. Yesterday's breakout in the Russell 2000 is shown on the daily chart below.



Assuming yesterday's breakout above the 50-day MA holds up, small caps may start seeing positive money flow that enables the Russell 2000 to start playing "catch up" to the rest of the indexes. Such action would help confirm yesterday's breakout in the broad market, as major relative weakness in small caps was one of the factors that sparked the mid-October correction (along with numerous days of higher volume selling that preceded the correction). However, if the Russell closes back below its 50-day MA within the next few days, there will be the possibility that yesterday's upward move leads to a failed breakout. Obviously, this will now largely depend on broad market action in the short-term. With the breakout above last week's sideways range occurring so quickly, one cannot deny the bullishness that remains abound. Nevertheless, given the long-term resistance levels in the S&P (two-year downtrend line and 50% Fibonacci correction), it may be wise to maintain reduced position size with any new long entries.

Open ETF positions:

Long - (none)
Short - RKH

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.