After attempting to rally off their lows for the past week, the main stock market indexes sold off sharply yesterday. The downside resolution of the recent trading ranges abruptly put an end to the near-term uptrends that were developing. Both the S&P 500 and Nasdaq Composite plunged 2.5%, as the Dow Jones Industrial Average fell 2.2%. The small-cap Russell 2000 and S&P Midcap 400 indices lost 2.1% and 2.4% respectively. All the major indices finished near the bottom of their intraday ranges. More significantly, the S&P 500 and Nasdaq both closed at their lowest levels since March of 2007. The Russell 2000 and S&P Midcap indices tumbled to fresh 52-week closing lows.

Total volume in the NYSE swelled 21% above the previous day's level, while volume in the Nasdaq ticked 9% higher. Yesterday, we said of Monday's light volume rally that "This is negative because low volume rallies can easily come undone by just one bout of distribution by the bears." Yesterday's action was a good example of this. When markets are climbing on declining volume, one must view the gains with great suspicion, especially in a bear market. Institutions let the retail "mom and pop" investors feebly rally stocks in weak markets, only to aggressively sell into strength of those gains the following day. Retail amateurs who don't know what's "happening under the hood" of the stock market are left holding the bag. This is what occurred yesterday. Until the overall market begins to register solid gains on increasing volume, odds of profitability will continue to strongly favor the short side of the market. When price-volume patterns begin to change more favorably, we'll immediately report it here.

Going into yesterday, we were bearish on both the intermediate and long-term bias of the overall market, but were neutral on the short-term. As such, we were positioned mostly in cash. Our sole position (SMH long) was merely a near-term bounce play off the low. But since the stock market showed clear downside resolution yesterday, we took action in several ETFs yesterday. First, we bought the Pharmaceuctical HOLDR (PPH) when it gapped down in the morning. Remember that we had been stalking PPH for potential entry, as it is a "defensive" play in the current bear market. Due to the lack of immediate upside follow-through, we later sold SMH for a scratch when it bounced in the final thirty minutes of trading.

The Oil Service HOLDR (OIH) showed resilience to the broad market for a while, but it finally joined the bear party as well. The negative turning point for the sector began on January 3, when the $OSX attempted to break out of its bullish consolidation to a new high, but failed to do so. It drifted down to support of its 50-day MA in the week that followed, then sliced through key support of its 50-day moving average yesterday. This is illustrated on the daily chart below:



While many industries are already beaten down substantially, the newfound weakness in the Oil and Oil Service ETFs presents ideal entry points on the short side. After OIH confirmed the breakdown below its 50-day MA, we took a bearish position in the Oil sector yesterday afternoon. However, rather than selling short OIH, we bought the inversely correlated UltraShort Oil and Gas ProShares (DUG). Leveraged to move 2 to 1 to the underlying stocks and in the opposite direction, DUG provides traders and investors with non-marginable cash accounts, a great way to still take a bearish position in the energy sector.

Upon scanning the international ETFs, we observed that the iShares Brazil Index (EWZ) was setting up for a short entry as well. Its daily chart is shown below:



As with OIH, EWZ recently failed its breakout attempt to a new high. Since dropping below its 50-day MA in mid-December, it has tried and failed to recover back above it. With such an abundance of overhead supply and multiple failed recovery attempts, the next move in EWZ should be lower. Our downside price target is support of the 200-day MA, about nine points below yesterday's close.

Similarly, the iShares Emerging Markets (EEM) and iShares Mexico Index (EWW) have bearish patterns on their weekly charts. Both have tested pivotal areas of horizontal price support several times since mid-November, but we expect them both to lose it within the next several days. The weekly chart of EWW is shown below:



After frivolously trying to rally in the week preceding yesterday's selloff, the U.S. stock market can no longer be considered "oversold." Therefore, don't be surprised if conditions get substantially worse before seeing major signs of life by the bulls. The S&P 500 and Dow Industrials are now in rather precarious states. The Dow just fell below its intraday low from August of 2007, while the S&P is only a few points from doing so. A break of the August low in the S&P will quickly put the index at a new 52-week low, attracting further growls of the bear. In the current environment, trying to find the one winning stock out of thousands is a daunting task. Instead, we will consider short sales in stocks and ETFs that are now breaking key levels of support, such as the ones discussed above. For anyone not comfortable with shorting for whatever reason, cash is definitely the place to be.

Things got pretty ugly in the after-hours market after Intel reported their quarterly earnings after the close. Last night, the Nasdaq futures were approximately 2% lower, while the S&P futures were off by 1%. If the post-market weakness persists into today's open, be prepared for high volatility in today's session. Nevertheless, remember that surviving a bear market is as simple as staying nimble and cutting losses quickly. Capital preservation, not huge profits, should be your primary goal in highly volatile markets.

Open ETF positions:

Long - PPH, DUG
Short - EWZ

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.