Stocks Are Bouncing—Now What?

03/17/2009 9:23 am EST

Focus: ETFS

Deron Wagner

Founder and Head Portfolio Manager, Morpheus Trading Group

Stocks capped a very strong week on a positive note last Friday (March 13), as the market's winning streak extended to four consecutive sessions of gains. After drifting lower throughout the morning, it initially appeared as though the major indices were headed for a slight correction, but the bulls resumed control in the afternoon, enabling the broad market to finish at its highest level of the week. The S&P 500, Dow Jones Industrial Average, and small-cap Russell 2000 each climbed 0.8%. The Nasdaq Composite and S&P Midcap 400 indices gained 0.4%. Finishing near their intraday highs, all the main stock market indexes advanced approximately 10% for the week.

Turnover eased in both exchanges. Total volume in the NYSE declined 11%, while volume in the Nasdaq was 17% below the previous day's level. Trading in the NYSE remained above 50-day average levels, but Nasdaq volume slipped below its average pace for just the second time in a month. In both the NYSE and Nasdaq, advancing volume beat declining volume by a modest margin of approximately three to two.

In the March 10 issue of The Wagner Daily, we discussed the clear relative strength the banking stocks had suddenly begun showing. Recall that the S&P 500 lost 1.0% the previous day, but the S&P Banking Index ($BIX) conversely zoomed more than 10% higher. Because the financial sector led the way lower when the overall market was selling off, we suggested the inverse would also be true, meaning that strength in financials could also precede broad market gains. Specifically, we said it would be "hard to imagine the overall stock market would not be inclined to move higher alongside of the financials, at least in the short-term." Indeed, it appears the sharp bounce in the financial arena was the initial impetus for the current rally. In the first four days of last week, the $BIX Index has logged a monstrous 48% gain! Unquestionably, that humongous bounce in banking stocks was a major factor in this week's S&P 500 advance of nearly 10%.

Yet, regardless of how impressive the current rally in banking stocks may be, it's important to realize financials were merely a beaten-down sector, bouncing off historical lows. While such action can, and often does, spark a short-term rally in the main stock market indexes, dead sectors simply cannot drive a market higher in the intermediate to long-term. For that to occur, there needs to be leadership among a few industry sectors, as well as individual stocks breaking out to new highs. So far, that's not happening, however, leading stocks have definitely begun to act better over the past several days. With stocks trying to reverse off multi-year lows, it may take some time for bullish setups to develop, assuming the broad market reversal holds up as well.

While many ETFs, such as the financials, have merely bounced off their lows, the Internet HOLDR (HHH) is poised to break out above a multi-month band of price consolidation, and is already above both its 20- and 50-day moving averages. It looks good for potential buy entry above the $35 level. Take a look:

Another interesting pattern is forming in Market Vectors Russia (RSX), which our sister service, the ETF Portfolio Tracker, already entered last week. The daily chart of RSX is shown below:

Unlike the domestic stock market indexes, notice how RSX has been showing relative strength by holding above its lows from November 2008. On numerous occasions throughout January and February, RSX tried to break down through its November 2008 low, but it held firm. Now, RSX has gapped up above resistance of both its 20- and 50-day moving averages. Further, the 20-day exponential moving average is about to cross up through the 50-day moving average, a bullish indicator of intermediate-term trend change. If RSX moves above last week's high of $13.75, bullish momentum should carry it substantially higher in the short to intermediate term. A protective stop can be neatly placed just below convergence of the 20- and 50-day moving averages, around $12.

Because last week's reversal occurred so suddenly and sharply, the main stock market indexes are showing "V bottom" formations. This means the angles of the short-term uptrend lines are roughly the same as the angles of the preceding downtrend lines before the market reversed. This is shown on the daily chart of the Dow DIAMONDS Trust (DIA), a popular ETF proxy for the Dow Jones Industrial Average:

As you may have noticed firsthand, trading the V bottom pattern can often be challenging because the rally is often too swift to allow traders to participate in the initial upward move. Although one could just blindly jump in on the buy side at the first sign of strength, such a strategy would have proved to have been quite costly over the past year, as a vast majority of rapid bullish reversals have failed. Therefore, a safer strategy for participating in the current rally is to wait for the market to prove itself. Specifically, we're waiting for the first day the major indices close significantly lower, then watching to see if they easily recover those losses, rather than falling apart, as they have done so many times in the past. At that point, when stocks begin heading back up after a significant pullback, we'll get the green light to begin more aggressive buying operations.

On an absolute basis, last week's percentage gains in the broad market were impressive. However, because the stock market had fallen so far, so fast, only the short-term trends changed from bearish to bullish. The intermediate-term trends are still pointing down. But if the main stock market indexes pull back, then subsequently rally above the preceding highs, the intermediate-term trends will change as well.

By Deron Wagner of Morpheus Trading Group

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