A vicious, broad-based sell-off slammed the market yesterday, causing the major indices to test their lowest levels of the year. Stocks gapped sharply lower on the open, then built on their early losses as the day progressed. The Dow Jones Industrial Average plunged 2.6%, the S&P 500 3.1%, and the Nasdaq Composite 3.8%. The small-cap Russell 2000 and S&P Midcap 400 indices nosedived 4.0% and 3.5% respectively. Though small-cap stocks often show leadership on "up" days within a market recovery, they also tend to get slammed the hardest in sharp market declines. A small bounce in the final ten minutes of trading lifted the major indices off their dead lows of the day, but stocks still finished near their intraday lows.

Turnover raced higher across the board, as mutual funds, hedge funds, and other institutions raced for the exit doors. Total volume in the NYSE swelled 73%, while volume in the Nasdaq jumped 51% above the previous day's level. In both exchanges, volume moved back above 50-day average levels. The higher volume losses caused both the S&P and Nasdaq to unquestionably register a bearish "distribution day," leaving no doubt institutions were leaning on the sell button yesterday. Market internals were as ugly as they come. In the NYSE, declining volume destroyed advancing volume by a margin of more than 60 to 1. The Nasdaq adv/dec volume ratio was negative by approximately 30 to 1. These ratios indicate the selling was extremely broad-based, sparing no industry sector. However, such extremely bearish internals also could indicate a near-term oversold condition.

In our June 28 commentary, we said, "This week, we will be closely monitoring the current pullback to determine if new lows are formed, or if higher 'swing lows' become established. If new lows are posted, it would be a continuation of the bearish trend that has been in place for several months. But if a 'higher low' and subsequent 'higher high' is formed, the overall tone and sentiment of the stock market should improve substantially. Finally, keep in the back of your mind that each of the major indices is still forming the right shoulder of a bearish 'head and shoulders' pattern on its weekly chart." With yesterday's decline, just two sessions later, the S&P, Dow, and Nasdaq are now testing their prior lows from June, which also correlates to major levels of horizontal price support from their February and May 2010 lows. Specifically, the S&P 500 finished at its lowest closing price of the year, but just a tad above its prior intraday low from May 25. Take a look:



The Nasdaq Composite closed below its intraday lows from both May and June, but is now just a few points above its prior closing low from early February. This is shown on the daily chart below:



Finally, it could be said the Dow Industrials is showing near-term relative strength because the index is still above its prior closing low from earlier this month:



Even if you're brand new to technical analysis, the charts above quickly make it apparent that the major indices are now testing critical support levels of paramount importance. The ability or inability of the main stock market indexes to hold at current levels will be a primary determining factor as to the market's next move in the intermediate-term, perhaps even for the rest of the year. This is doubly compounded by the fact that several of the major indices are each testing the "neckline" of their "head and shoulders" patterns on the weekly charts. A convincing breakdown below current levels will correspond with bearish follow-through on the "head and shoulders" patterns. If that happens, technical analysis suggests an anticipated downward move roughly equivalent to the distance from the top of the head, down to the neckline. In the case of the S&P 500, that equates to a further decline of approximately 13% below the current price. The longer-term weekly chart of the S&P 500 illustrates this scenario:



Most of the major indices have declined in six of the past seven days. In this brief period, the S&P has lost 6.8% and the Nasdaq has tumbled 7.5%. As such, it's fair to say stocks are "oversold" on a short-term basis. We generally don't like to use the term "oversold" because stocks in a sharp downtrend often become even more "oversold" than most people would imagine before eventually bouncing. Still, we point out when markets appear "oversold" as a warning that the reward/risk ratio of entering new short positions may be very poor. Although the main stock market indexes are in danger of convincingly breaking down to new lows, which could lead to another leg down in the intermediate-term, there could easily be a significant bounce in the near-term. On that bounce, if stocks quickly stall, it would be a better point at which to initiate new short positions, in anticipation of follow-through on the head and shoulders patterns. For now, we're steering clear of ETFs correlated directly to the direction of the broad market. By maintaining a portfolio of open positions with a low stock market correlation, we have stayed out of harm's way as stocks have recently sold off. Today concludes the second quarter and the first half of 2010.

Open ETF positions:

Long - TLT, UNG, UUP
Short (including inversely correlated "short ETFs") - USO

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.