Broad market indices gapped lower on the open and sold off sharply during the first hour of trading. The steep decline out of the gate put pressure on those who bought the recent breakout to new swing highs, as their positions were quickly taking on water. Though the ugly internals and heavy selling action in the morning pointed to a potential trend day to the downside, the afternoon session failed to follow through, as the price action chopped higher into the close across the board. The late day push created a bear flag look on the hourly charts of most averages. The relatively weak small-cap Russell 2000 led the market lower, closing down 2.4%. The S&P Midcap 400 was not far behind at 2.1%. The Nasdaq Composite fell 1.7%, and the S&P gave back 1.3%. The Dow held up the best once again, sliding down 0.9%.

While Wednesday's selling into strength was subtle, yesterday's heavy volume distribution was not. Turnover increased by 10% on the Nasdaq and 2% on the NYSE. Market internals confirmed the selling, as declining volume beat advancing volume by 8 to 1 on the NYSE and 5 to 1 on the Nasdaq. There was no place to hide yesterday, as nearly all industry groups closed in negative territory.

In keeping with the recent trend, yesterday's selloff may have started the end of the month selling we have seen over the past few months in the S&P 500. Beginning in August, the chart below illustrates the strong trending action at the start of each month. The trend eventually stalls out after options expiration, and is then followed by some late month profit taking.



If this trend is to continue, then we could see some follow-through to the downside until the end of the month. Most pullbacks since July have been in the 4% to 6% range, so we'd expect the same type of correction to take place, which would bring the S&P 500 around the 50-day moving average. This would also coincide with a 50% Fibo retracement of the move from 11/2 to 11/16. The one caveat to this scenario is that next week is a holiday-shortened week, which tend to be bullish for broad market price action.



We are beginning to see a decline in the breadth of the rally, as evidenced by the divergence between the Nasdaq Composite and the Nasdaq A/D line on the chart below (the A/D line is simply the advancing issues minus the declining issues). The A/D line is a secondary indicator that can be used to confirm the price action of an index. When the A/D line moves in step with the index it indicates that the breadth of the market is expanding, which is bullish. Note the recent bearish divergence in the Nasdaq A/D line from the index. While the Nasdaq has set a higher high in November, the A/D line has barely budged off the lows, which signals that the rally is pushing higher with less participation. We are not calling a top in the Nasdaq, we are merely pointing out some potential warning signs.



We are adding the PowerShrares Golden Dragon China (PGJ) to our list of bullish setups for next week (joining XHB, DAG, and USO). The current false breakout in PGJ in our minds can be quite constructive, as it serves to washout all the weak hands. Once the short-term selling subsides, the next move out will have the potential to be a legitimate breakout as those who sold will look to re-enter at higher prices.



With the broad market potentially pulling back in the short-term, we are looking at the iShares Securities Broker-Dealers (IAI) as a possible short setup. IAI showed major relative weakness during the last correction that began in mid-October, and was one of the few industry sector ETFs that fell to set a “lower low” below its prior low from early October. Now, after recovering to its 50-day MA, IAI is stalling, and may be poised to roll over again. We like it for a quick, momentum-based short sale entry below yesterday’s low of $28.11, with a target of the prior lows, around the $26.80 area. Since the target is relatively small, the stop must be as well. Placing a protective stop just above yesterday’s high and 20-day exponential moving average, around $28.70, still provides a positive reward-risk ratio for the setup (this is not an official setup, just a heads up for aggressive traders):



Open ETF positions:

Long - DAG
Short (including inversely correlated "short ETFs") - 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.