The broad market suffered a severe beating in the first week of the new year, as stocks swooned on higher volume last Friday. The major indices gapped lower on the open, moved lower throughout the morning, consolidated for a few hours, then suffered another bout of selling in the afternoon. The Nasdaq Composite plummeted 3.8%, its biggest single-day loss in nearly a year. The S&P 500 and Dow Jones Industrial Average fell 2.5% and 2.0% respectively. The small-cap Russell 2000 lost 3.2%, while the S&P Midcap 400 shed 2.9%. The steady intraday downtrends caused all the main stock market indexes to close at their worst levels of the day, as well as the lows of the holiday-shortened week.

Turnover surged higher across the board, causing both the S&P and Nasdaq to register another bearish "distribution day." Total volume in the NYSE increased 21%, as volume in the Nasdaq similarly rose 28% above the previous day's level. Heavy selling by mutual funds, hedge funds, pensions, and other institutions caused volume in both exchanges to move back above 50-day average levels for the first time since December 21. Market internals were atrocious. In both the NYSE and Nasdaq, declining volume slaughtered advancing volume by ratios of more than 14 to 1. Nevertheless, such bearish ratios are often indicative of near-term oversold conditions that precede a bounce.

If there is anything good about last week's action, it's that the stock market's indecision from last month appears to be resolved. As technical "trend traders," we can profit equally in both broad market uptrends and downtrends. The most challenging environment, however, is one in which stocks oscillate in a choppy, sideways range. When this occurs, divergent patterns of relative strength and weakness still present themselves, but whippy markets require more precision timing on entries and exits, as well as shorter overall holding periods. Throughout December, the major indices toyed with pivotal resistance levels such as the 50 and 200-day moving averages, making it tricky to capture large gains on either side of the market. Now, the bearish "head and shoulders" patterns on the longer-term weekly charts are beginning to follow-through to the downside, overriding the less clear patterns on the daily charts. This should make it easier to profit throughout the rest of January, by short selling bounces into resistance of the recently confirmed downtrends.

The S&P 500 and Dow Jones Industrial Average are now testing key support of their November lows, while the Nasdaq Composite, Russell 2000, and S&P Midcap 400 indices have already fallen below their November lows. In the coming week, the S&P and Dow are likely to bounce off support of their November lows, but the breakdowns in the Nasdaq, Russell, and S&P Midcap indexes may weigh heavily on the S&P and Dow, causing any bounce to be short-lived. Looking quite ominous, the Russell 2000 has already sliced through its August low. This is shown below on the weekly chart of the iShares Russell 2000 (IWM), a popular proxy for the small-cap index:



Notice that IWM bounced off support of its August low both in November and December, but finally fell below it last week. That horizontal support level was also the "neckline" of its "head and shoulders" chart pattern, which should now act as firm resistance. Therefore, any rally attempt into the prior lows should provide us with a low-risk short selling entry point. Trading at a fresh 52-week low, there is no near-term support level to worry about, as the low of July 2006 is the next major support level for the Russell. Small-cap stocks clearly have the most bearish chart patterns of any major market segment.

The weekly chart of the Nasdaq Composite shows how the index moved below its prior low from November, but is still above its August low. Again, any rally into resistance of prior support of the November low presents an ideal short entry point in the Nasdaq. Next major support is obviously the August low:



With a series of "lower highs" and "lower lows," all of the main stock market indexes are now in confirmed primary downtrends. Yet, this does not mean that profiting on the short side of the market will be as easy as shooting fish in a barrel. Countertrend retracements in bear markets are vicious, often stopping out "late to the party Charlies" who sold short at the bottom, only to move to new lows one week later. Bear markets also move faster on the "down" days than do bull markets on "up" days. This means that bear markets rarely provide traders with second chances for low-risk short entries if they hesitated at the proper entry points the first time.

Given the current market weakness, now is a good time to remind you about the inversely correlated ProShares Short and UltraShort ETFs. Non-marginable cash accounts such as IRAs prevent investors and traders from selling short, but these ETFs provide a way to take bearish positions without being short.

The number one priority in a bearish market must be capital preservation! Be one hundred percent disciplined to quickly close losing positions that hit your stop losses. Further, take profits quicker than usual on winning trades. For us, all bets are off on the long side of the market, but the short side requires waiting for proper entry points on bounces into resistance. We view the stock market as being "oversold" in the near-term, but not in the longer-term. With the market's recent indecision resolved, we are now looking for short entry points on ETFs that have broken down below key support levels. Rather than guessing how long the current downtrends will last, we will simply ride the trends until they reverse.

Open ETF positions:

Long - (none)
Short - (none)

Deron Wagner is the Founder and Head Trader of both Morpheus Capital LP, a U.S. hedge fund, and Morpheus Trading Group, a trader education firm launched in 2001 that provides daily technical analysis of the leading ETFs and stocks. For a free trial to the full version of The Wagner Daily or to learn about Wagner's other services, visit MorpheusTrading.com or send an e-mail to deron@morpheustrading.com.