Building on the previous day's bearish momentum, stocks suffered another day of sharp losses that caused the major indices to slice through key short-term support levels. The broad market opened nearly flat, but sellers quickly took control, causing stocks to tumble through the morning session. The main stock market indexes stabilized in the afternoon, but were unable to reclaim any ground. The Nasdaq Composite plunged 1.1%, the S&P 500 1.9%, and the Dow Jones Industrial Average 2.0%. The small-cap Russell 2000 and S&P Midcap 400 indices skidded 1.8% and 1.3% respectively. All the major indices closed near their intraday lows.

One of the most negative aspects of yesterday's trading was the sharply higher volume that accompanied the broad-based losses. Total volume in the NYSE surged 42% above the previous day's level, while turnover in the Nasdaq swelled 21%. In both exchanges, it was the highest volume since December 18, a day in which turnover was inflated due to year-end options expiration. Yesterday was the second straight day of higher volume losses across the board, and the fourth such "distribution day" within the past seven sessions. Over the past month, the S&P 500 has already registered six "distribution days." Mutual funds, hedge funds, and other institutions were slow to re-enter the markets in the first week of the new year, but their trading operations have clearly resumed back to normal. But unlike recent months, their bias has been on the sell side, as evidenced by the recent, bearish price to volume patterns in the broad market.

Until yesterday, the preceding seven days of trading was simply a roller coaster ride. Though prices were volatile, the major indices were stuck in a pattern where each successive day canceled out the prior day's price action, making it very challenging for trend traders to see follow-through in either direction. But yesterday's session changed all that, as stocks convincingly followed through on Wednesday's losses. This caused the major indices to break key levels of short-term support, thereby fanning the wave of downside momentum.

In yesterday's commentary, we said of the January 20 low in the S&P 500 Index, "Should the price action return back below this point (1,129), then we would expect a deeper pullback to the 50-day MA, around 1,113." That's exactly what happened yesterday morning, as the price of the benchmark index moved swiftly lower after failing to hold above near-term support of its prior day's low and 20-day exponential moving average. Upon coming into more significant support of its 50-day moving average at mid-day, the S&P 500 merely consolidated near its intraday low in the afternoon.

Below is a daily chart of the S&P 500 SPDR (SPY), a popular ETF proxy of the S&P 500 Index. Notice yesterday was the first time SPY touched its 50-day MA since early November of 2009:



Since the current uptrend began in March of 2009, the 50-day MA has provided solid price support for the S&P 500. There have only been two periods since then, once last July and once in late October/early November, where the price of the index fell below the 50-day MA. On both occasions, the price traded below the 50-day MA for only one to two weeks before the bulls returned to the scene, propelling the index to new highs again. Showing slight relative strength to the S&P 500, the Dow Jones Industrial Average only fell convincingly below its 50-day MA once, in July of 2009, since its current uptrend began. However, unlike the S&P 500, the Dow actually closed yesterday's session firmly below its 50-day MA. This is shown on the daily chart of the Dow Jones DIAMONDS (DIA):



Based on the recent string of "distribution days," bearish momentum will likely cause the S&P 500 to "undercut" its 50-day MA in the near-term. If it does, we'll be monitoring to see if the index snaps back above it a week later, as it did in July and October/November of 2009. One positive aspect of the correction is the Nasdaq remains above its 50-day MA. Continued relative strength in the tech-heavy index could help the S&P and Dow to hold up, so we'll be watching for signs of institutional rotation that confirm this possibility.

In the January 19 issue of The Wagner Daily, we said of the major indices, "a retracement to the area of the 50-day moving averages would actually be positive for the longer-term health of the market, as it would allow stocks to digest their sizable gains of 2009. Furthermore, a decent pullback would also provide us with new ETF buy setups, such as those we've been discussing and monitoring for a pullback over the past week." Now that we're seeing that retracement, we will closely monitor the price action of the strongest ETFs we've been discussing over the past two weeks. Those that pull back to major levels of support, while continuing to exhibit relative strength, will be considered for buy entry unless the major indices fail to hold up near their 50-day moving averages this time. Our patience to hold off on aggressively entering new long positions earlier this month is now paying off. As the market corrects from its "overbought" condition, new opportunities with much more attractive reward-risk ratios will soon present themselves. We'll be ready.

Open ETF positions:

Long - UUP, PGM
Short (including inversely correlated "short ETFs") - EEV

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.