Stocks built on the previous day's reversal by scoring a moderate round of gains yesterday, but overall price action was indecisive and lacked momentum. The Nasdaq Composite gained 0.6%, the S&P 500 0.8%, and the Dow Jones Industrial Average 0.9%. The small-cap Russell 2000 and S&P Midcap 400 indices were higher by 1.1% and 0.9% respectively. Despite the gains, it was a choppy session driven by divergent interpretations of yesterday afternoon's speech by Fed head Ben Bernanke. In the end, the major indices settled in the upper third of their intraday ranges.

Unfortunately, turnover failed to increase alongside of the market's advance. Total volume in the Nasdaq declined 10%, while NYSE volume was on par with the previous day's level. A second straight day of higher volume gains would have pointed to the continued presence of institutional support, but mutual funds, hedge funds, and other big money players apparently showed a bit of indifference to the prior day's bullish action. Market internals were positive, but not by a wide margin. Advancing volume in the NYSE exceeded declining volume by 3 to 1. The Nasdaq adv/dec volume ratio was positive by just under 2 to 1.

As mentioned in yesterday's commentary, we bought the S&P Financial SPDR (XLF) late on Wednesday afternoon. Since XLF is in such a strong downtrend, our intention was nothing more than capturing momentum from a near-term bounce off the lows, NOT a reversal of trend. Since it showed solid relative strength to the broad market during Wednesday's reversal, we figured it would continue to do so for at least a day or two more. This is exactly what happened, as it rallied as much as 4% yesterday before settling 1.7% higher. Because it approached several near-term resistance levels so quickly, we sold into strength near its high yesterday afternoon, netting a nice 3% gain on a holding period of just one-day. The daily chart of XLF below illustrates these resistance levels:



Notice how XLF reversed after running into convergence of two near-term resistance levels: its prior low from November 2007 (the dashed horizontal line) and the 10-day moving average (the purple dotted line). The prior low from November is resistance because it was formerly a key area of support. This is a good example of how prior support levels become new resistance after the support is broken. Second, the 10-day MA often acts as support or resistance for very short-term periods. Since a brief holding period was our intention, we drilled down to the 10-day MA instead of using the more common 20-day MA. The combination of these two resistance levels gave us valid reasons to swiftly take profits near the high. As you can see, XLF reversed significantly after running into this convergence of resistance levels.

In the January 8 issue of The Wagner Daily, we discussed the relative strength in "defensive" sectors. The Utilities HOLDR (UTH), for example, was testing its 52-week high at the time. Another "defensive" sector showing positive institutional money flow is Pharmaceuticals. Below is a daily chart of the Pharmaceutical HOLDR (PPH):



PPH has climbed steadily higher since forming a "double bottom" on January 4. This is impressive because the S&P 500 continued to get slammed through January 8, but PPH ignored the broad-based weakness. Yesterday, PPH took a rest and began to consolidate near its high. It may continue to do so for a few more days, but the subsequent breakout above the high of its near-term range represents a decent long entry. One potential problem is the prior high from last month. To minimize risk, consider buying a partial entry just above the high of its short-term range, then adding to the position after it clears resistance of its prior highs. With institutions now looking for low-risk places to rotate funds, Pharmaceuticals should continue to show strength for a while. Note the steadily increasing volume in PPH over the past four days -- proof of institutional buying. The same goes for the Biotech industry. Still, reduced position size on all long entries right now is advisable.

After such a sharp sell-off in a short period of time, Wednesday's bullish reversal day should have led to a healthy appetite for buying stocks yesterday. Instead, traders and investors lacked ardency. Most of yesterday's top-gaining stocks were in "defensive" sectors such as Healthcare and Gold. Leading growth stocks, always an accurate barometer of the market's true health, were relatively quiet. With other broad market corrections over the past year, the eventual bullish reversal days led to short-term buying frenzies that quickly sent the short sellers scrambling for cover. So far, this has not happened yet.

It's premature to declare the retracements off the lows as having already run their course. The main stock market indexes could easily dip lower over the next several days, form a short-term double bottom near Wednesday's lows, then rip higher. Therefore, any new short positions should be deployed selectively. Getting aggressive on the short side right now, without waiting for another bounce in the overall market, carries a negative risk/reward ratio. Conversely, yesterday's action was not encouraging enough to buy stocks and ETFs for anything more than very short-term trades.

Successful traders and investors take what the market gives them; they don't force positions to conform to their wishes. Further, the most profitable traders always "trade what they see, not what they think!" Following these simple, yet powerful, rules is a great way to preserve capital in the current market, while netting occasional profits as well. If you can't trade like a sniper right now, stay on the sidelines until the market clearly shows its hand for the direction of its next move.

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.