After weeks of directionless price action and numerous "headfakes" in both directions, the broad market finally made a decisive break out of its sideways trading ranges. Unfortunately for the bulls, the direction of the break was to the downside. After gapping down on the open, stocks trended steadily lower throughout the entire day. Aided by bearish momentum caused when the major indices broke key technical levels of support, each of the main stock market indexes suffered whopping losses of approximately 3%. The tech-dominant Nasdaq Composite and small-cap Russell 2000 indices registered identical losses of 3.2%, as the benchmark S&P 500 and blue-chip Dow Jones Industrial Average sustained matching declines of 3.0%. The S&P Midcap 400 shed 2.4%. After a feeble bounce in the final ninety minutes of trading fizzled out, all the major indices closed at their dead lows of the day.

Significantly higher turnover accompanied yesterday's carnage, causing both the S&P 500 and Nasdaq Composite to sustain another bearish "distribution day." Total volume in the NYSE increased 7% above the previous day's level, while volume in the Nasdaq rose 13%. Volume in both exchanges moved back above 50-day average levels for the first time in four weeks, as mutual funds, hedge funds, and other institutions rushed for the exit doors. In yesterday's commentary, we said, "The Nasdaq has now registered four days of higher volume losses in recent weeks. Typically, the presence of more than three such days of institutional selling is enough to trigger a wave of downward momentum. In mid-May of 2008, the Nasdaq suffered four 'distribution days' over a short period that eventually triggered the June - July sell-off." Interestingly, yesterday's plunge immediately followed the fourth day of higher volume losses in the Nasdaq. Volume is not only a leading indicator, but it's also one of the few indicators that never lies. That's why we carefully analyze the stock market's price to volume relationship on a daily basis.

As one might easily surmise, yesterday's bearish price action was an important turning point for the near and intermediate-term direction of the overall stock market. Due to nearly a month of erratic, sloppy price action in the major indices, we had been maintaining a minimal number of ETF positions. Despite buying a few ETFs with relative strength, and selling short a few with relative weakness, positions in recent weeks quickly stopped out due to a lack of overall trend in the market. But while yesterday's sell-off may have been bad news for traditional "buy and hold" investors, we're pleased the stock market appears to have made up its mind as to which direction it wanted to go. As we kept saying last week, we indeed finally saw the real direction of the market, just a few days after the Labor Day holiday had passed. Fortunately, we now at least know which side of the market will offer the highest chance of profitable trades in the near to intermediate-term.

In hindsight, we could have immediately entered a few new short positions as soon as the S&P, Dow, or Nasdaq broke below the lows of their trading ranges yesterday. However, given the stock market's recent history of intraday "fakeouts" that have not followed through in the anticipated direction, we opted for the safer route of waiting for actual closing prices below the key support levels. Clearly, we now have those convincing closing prices that correspond to key breaks of technical support. Given this knowledge, our new plan is to enter new short positions as soon as the broad market begins to bounce. All bets on the long side of the equities market are now off. Even the healthcare ETFs, the last hope of persistent relative strength, broke down yesterday. However, rather than initiating short sales in old-school ETFs such as S&P 500 SPDR (SPY) or Dow Jones DIAMONDS (DIA), we will be buying the inversely correlated ProShares UltraShort ETFs instead. The main benefit of this approach is the ability to take bearish positions in a non-marginable, cash account, such as an IRA. Furthermore, the "UltraShort ETFs," as compared with just the "Short ETFs," enable traders to reap larger potential profits with less deployment of buying power. This is because the UltraShort ETFs move at an inverse 2 to 1 ratio of the underlying index, thereby giving traders more "bang for the buck."

In yesterday morning's commentary, we suggested that, due to its recent relative weakness, the basic materials sector would become one of the hardest-hit industries if the broad market lost support. That's exactly what happened, as the S&P Basic Materials SPDR (XLB) tumbled 3.6%. The inversely correlated and leveraged UltraShort Basic Materials ProShares (SMN) rocketed above its prior high from early August, scoring an impressive gain of 8.3%! We intentionally held off on "officially" buying the SMN breakout for the cautious reason mentioned in the preceding paragraph. However, now that the major indices have broken support with conviction, we'll be looking for a buy entry into SMN on a pullback to near the area of its breakout level. That is around the $40 to $40.50 area, or near the 20-period exponential moving average (EMA) on the hourly chart. We've annotated the potential "buy zone" area on the short-term hourly chart of SMN below. Remember that the 20-period EMA on the hourly timeframe is often a great indicator for short-term support on pullbacks:



Waiting for the major indices to bounce into new resistance of the prior lows, or at least the 20-period EMAs on the hourly charts, presents us with a much more positive reward/risk ratio than blatantly chasing new short positions in the midst of a high-momentum downward move. In our next issue, we'll take an updated look at the chart patterns of the major indices, in order to determine the most ideal ETF short entry points for the S&P 500, Nasdaq Composite, and/or Dow Jones Industrial Average. A likely scenario is that we'll more broad-based downward pressure in today's session, followed by a bounce attempt early next week. We'll have you prepared when/if that happens. If, by chance, the major indices bounce into resistance as early as today, we'll inform regular Wagner Daily subscribers of any new ETF trade entries via real-time Intraday Trade Alert.

Open ETF positions:

Long - FXE (quick bounce play, entered near yesterday's low, due to major support of Dec. 2007 low)
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.