Stocks got off to an encouraging start in 2010, as the major indices surged sharply higher and confirmed their recent breakouts. After jumping higher in the morning, the major indices merely drifted sideways throughout the rest of the day, but retained their gains into the close. The Nasdaq Composite advanced 1.7%, the S&P 500 1..6%, and the Dow Jones Industrial Average 1.5%. Small and mid-cap stocks turned in an even stronger performance, hinting at a continued appetite for risk amongst investors. Both the Russell 2000 and S&P Midcap 400 indices rallied 2.4%. All the main stock market indexes closed near their best levels of the day.

As expected, volume returned to the markets. Total volume in the NYSE swelled 50%, while turnover in the Nasdaq increased 55% above the previous day's level. Despite the significantly faster pace of trading, volume levels remained below average. Still, volume in both exchanges was the highest of the past several weeks. The higher volume gains across the board also enabled both the S&P and Nasdaq to register a bullish "accumulation day," indicative of institutional buying. Strong market internals confirmed the strength. In both exchanges, advancing volume exceeded declining volume by a margin of approximately 6 to 1.

At the end of every year, we do an honest assessment of our performance as professional traders. Inevitably, there are things we did very well, and actions that could have been done differently. Without such self-assessment, it's impossible to grow as traders. Upon reflecting on our 2009 performance, we came to the conclusion one mistake was paying too much attention to the performance of the major indices, rather than individual sector performance. At times, this caused us to think the broad market was "overbought," which caused us to be slightly too passive with regard to entering new positions. In hindsight, the actuality was merely a rotation of institutional funds shifting from one industry to another. As such, we've resolved to re-focus on sector rotation in 2010.

Based on the first day of trading in the new year, we're on the right track with following the continual flow of funds from one industry sector to another. Yesterday, we pointed out the bullish setup in the S&P Select Energy SPDR (XLE), and suggested it could become a leading ETF in the short-term. On the first day of the new year, that's exactly what happened. Zooming 3.2% higher yesterday, XLE showed relative strength by outperforming the gains of the major indices. After pulling back to support of its prior downtrend line, as well as its 20 and 50-day moving averages, XLE is now positioned for a run to test its prior highs from last October. This is shown on the daily chart below:



Yesterday's strength in the energy sector caused our buy setup in XLE to trigger for long entry, five minutes after the open. At the same time, technology stocks, leaders of late 2009, merely kept pace with the broad market, and even showed a bit of relative weakness. In addition to energy, another sector that could show leadership in the near-term is financials. Take a look at the daily chart of the S&P Select Financial SPDR (XLF), a popular ETF proxy for the overall financial industry:



Prior to the last week of 2009, the S&P 500 was stuck in a choppy, seven-week trading range. As such, our portfolio was lightly positioned on both sides of the market. Yesterday's broad-based strength caused our bearish position in UltraShort Financial Bear 3x (FAZ) to hit its stop price, but our bullish position in the Semiconductor HOLDR (SMH) moved nearly 2% higher. Since our long-term goal is to generate consistent profits with minimal risk, regardless of market conditions, we don't regret FAZ hitting our stop price. While the S&P 500 was in a trading range, being hedged on both sides of the market made sense. However, now that stocks have confirmed last week's strength, we are positioned only on the long side of the market, with SMH and XLE.

In yesterday's commentary, we said of last Thursday's pullback, "the benchmark S&P 500 (is set) to kick off 2010 right at support of its recent breakout level." That support provided an impetus for investors and traders to jump back into the markets, propelling stocks higher. With the exception of the S&P Midcap 400, all the main stock market indexes closed above last week's highs, on higher volume, at fresh 52-week highs, which confirms last week's low-volume breakouts. However, with nearly all the gains occurring on the opening price action, rather than intraday, we will now look for follow-through in the coming days. Assuming the follow-through comes, we will be looking to add additional long positions to our portfolio. Specifically, we are planning to buy strong ETFs that have broken out, after they pull back to key support levels (as XLE did last week).

Open ETF positions:

Long - SMH, XLE
Short (including inversely correlated "short ETFs") - (none)

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.