After trending steadily higher for weeks, with nary a significant loss along the way, stocks finally ran into a bit of selling pressure last Friday. Several of the major indices gapped to new 52-week highs on the open, but traders immediately sold into strength, sending the broad market into a substantial downtrend that persisted until mid-day. In the afternoon, the major indices consolidated near their lows of the day, briefly broke down to new intraday lows, then recovered slightly in the final minutes of trading. The Dow Jones Industrial Average lost 0.3%, the S&P 500 0.5%, and the Nasdaq Composite 0.7%. Small and mid-caps showed relative weakness for a change; the Russell 2000 shed 1.1% and the S&P Midcap 400 indices fell 1.0%. The main stock market indexes closed around the bottom third of their intraday ranges. Despite the day's losses, the broad-based indices still scored another round of weekly gains.

Perhaps the most negative aspect of last Friday's sell-off was the sharply higher volume that accompanied it. In the NYSE, total volume rocketed 111% above the previous day's level. It was the most active session in the NYSE so far this year. Turnover in the Nasdaq surged 39%. Granted, much of the faster pace of trading could be attributed to Friday being a "quadruple witching" options expiration day. Nevertheless, both the S&P and Nasdaq convincingly registered a bearish "distribution day," indicative of institutional selling. After such an impressive run, it's normal to eventually see a bit of distribution, and a healthy market can usually absorb a day or two of higher volume selling. Still, we'll be on the lookout for further "distribution days" this week.

Recently, we sold our position in iShares Xinhua China 25 Index (FXI) into strength, locking in a solid gain. We originally bought FXI after it formed an "inverse head and shoulders" pattern in late February, then took profits after it rallied into resistance of its four-month downtrend line. Upon exiting, we said we would look to re-enter FXI on a breakout above that downtrend line. Now, one week later, it looks as though FXI may be poised to break out above that downtrend line. Take a look:



After a test of the downtrend line on March 17, the intraday highs of each of the past two days have coincided with resistance of the four-month downtrend line from the November 2009 high. As such, a rally above the March 19 high (over the $41.50 area) would present a valid buy entry for at least a partial position into FXI. The remainder of the shares could be added on confirmation of the downtrend line break, which would be a rally above the March 17 high of $41.86. With price consolidation tightening up in recent weeks, above its 50-day MA, a breakout could be imminent. Regular subscribers will see our detailed trigger, stop, and target prices below. Since it's an international ETF, it's also a bonus that the movement of FXI is not necessarily correlated directly to the direction of the U.S. markets.

As we enter the new week, all the major indices are now trading above prior resistance of their January 2010 highs, in fresh 52-week high territory. Even the laggard Dow joined the rest of the major indices by rallying to a new high on March 17. However, after last Friday's decline, the Dow is now just 0.1% above its breakout level, while the S&P 500 is sitting less than 1% above its January high. As such, just one day of moderate losses could cause two key, benchmark indexes to slide back into the prior ranges. If that happens, traders would need to be concerned about the possibility of failed breakouts to new 52-week highs. Such action often causes stocks to reverse in a hurry, as the bulls who bought the breakout quickly become trapped, thereby forcing them to sell. The sudden reversal of momentum subsequently attracts the short sellers, which causes downside momentum to feed on itself. Of course, this hasn't happened yet, and stocks could just as easily continue marching higher this week. Nevertheless, it's wise to be prepared for potential scenarios that could occur with the S&P and Dow at such pivotal levels. If we do get a substantial retracement in the broad market, it will create new buying opportunities in strong ETFs that pull back to solid support levels (IBB, IAT, XRT, KIE, INP, et cetera). Therefore, we would certainly welcome a healthy, short-term correction.

Open ETF positions:

Long - UUP
Short (including inversely correlated "short ETFs") - XME

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.