Stocks followed up the previous day's breakout with another round of gains last Friday, as near-term market sentiment continued improving. The major indices chopped around in a sideways range throughout the first half of the day, but rose to new intraday highs in the early afternoon. The Nasdaq Composite and Dow Jones Industrial Average scored identical gains of 1.0%. The S&P 500 advanced 0.8%. Confirming investors' greater appetite for market risk, small and mid-cap stocks again showed substantial relative strength. The Russell 2000 and S&P Midcap 400 indices climbed 2.4% and 1.5% respectively. Closing just above their previous day's highs, all the main stock market indexes settled near their best levels of the day and week.

Turnover was mixed. Total volume in the Nasdaq increased 10% above the previous day's level, enabling the Nasdaq Composite to register another bullish "accumulation day." However, trading in the NYSE eased 2%. Volume in the Nasdaq swelled to its highest level since July 1, and also moved back above its 50-day average level for the first time since the same day. Market internals in both exchanges were solid. In the NYSE, advancing volume exceeded declining volume by nearly 4 to 1. The Nasdaq adv/dec volume ratio was positive by more than 2 to 1.

As the market has been starting to show more positive price action, our near-term bias has shifted from neutral to cautiously bullish. Due to major overhead resistance of the June highs, as well as the 200-day moving averages for several of the major indices, it's still too early to aggressively start "backing up the truck." Since a high degree of caution is still required in the current environment, it's important to focus on ETFs and stocks with the highest odds of outperforming the broad market to the upside, which also have lower odds of falling apart on the first broad market pullback. Simply, we especially want to focus on tickers that have been showing the most relative strength to the main stock market indexes.

Recently, we said the easiest way to spot current relative strength is to locate ETFs that are already trading at or above their prior highs from June. Since all the major indices are still well below their respective June highs, this is a quick, effective benchmark measurement of near-term relative strength. Furthermore, it's even better leadership if an ETF is not only above its June high, but is also trading at or near its 52-week high as well. In that regard, only a handful of ETFs qualify.

Several domestic, industry sector ETFs have already moved above their June highs, but are still substantially below their 52-week highs. This list includes sectors such as: steel (SLX), computer networking (IGN), basic materials (XLB), agricultural commodities (DBA), and solar energy (TAN). But there is still a big difference in relative strength amongst these ETFs. Whereas SLX, IGN, and XLB all formed "lower lows" in early July, DBA and TAN were already showing clear relative strength by conversely forming "higher lows," above their June lows, at the same time. As such, it's no surprise that both DBA and TAN were among the few sector ETFs to lead the broad market to "higher highs." The "higher low" in DBA is one of the main factors that prompted us to buy this ETF on June 30. Since it continues to act well and is showing a solid unrealized gain, we remain long the position. As for TAN, we're stalking it for potential pullback entry this week. The setup is illustrated on the daily chart below:



As for ETFs above their June highs, as well as at or near fresh 52-week highs, that list almost exclusively belongs to the international ETFs, which have been showing more relative strength to the broad-based indexes than any of the industry sector ETFs. Strong international ETFs to keep on your watchlist include: Thailand (THD), Singapore (EWS), India (INP), Brazil Smallcaps (BRF), Indonesia (IDX), and Chile (ECH). As all of these ETFs formed "higher lows" in early July, subsequently rallied above their June highs, and are now trading at or near their 52-week highs, it's fair to say every one of these ETFs has a much more robust pattern than any of the domestic main stock market indexes. The charts below detail the potential pullback entries into iShares Chile Index (ECH) and Market Vectors Brazil Smallcap (BRF), followed by a potential breakout entry into iPath India Index (INP):







In raging bull markets, buying breakouts above bases of consolidation can be a very profitable strategy. But in less convincing markets, such as the one we're in now, a lower risk strategy for buy entry may be to wait for strong ETFs to subsequently pull back to near-term support levels. This type of patience enables one to have a relatively tighter stop price, thereby increasing the reward-risk ratio for the trade. Although we listed INP as a possible breakout entry, one concern is that it gets out of sync with the broad market by breaking out at the same time the U.S. major indices bump into resistance of their 200-day MAs and/or June highs. Conversely, waiting for pullback entries in ECH, BRF, or any of the other international ETFs that have broken out, could potentially give us a profit buffer if the major indices subsequently attempt to resume last week's strength, but stall. Overall, we're slowly seeing more buy setups out there, but it remains an environment where patience and discipline is of paramount importance.

Open ETF positions:

Long - SMH, DBA, TLT, UNG
Short (including inversely correlated "short ETFs") - GDX

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.