Gapping several percent higher on the open, the broad market initially followed through on the incredible bullish momentum of the previous day's session, but traders, not surprisingly, immediately sold into strength of the massive rally. Stocks gave back their opening gains within the first hour of trading, drifted sideways through mid-day, then fell to new intraday lows in the afternoon. Nevertheless, buying interest appeared in the final hour of trading, for a third straight day, enabling the major indices to trim their closing losses. The S&P 500 fell 0.5% and the Dow Jones Industrial Average declined 0.8% -- rather small losses considering both indexes surged more than 11% the previous day. The Nasdaq Composite, however, showed significant relative weakness by dropping 3.5%. The small-cap Russell 2000 and S&P Midcap 400 indices shed 2.6% and 2.3% respectively. The S&P 500 and Dow Jones Industrial Average closed at the bottom third of their intraday ranges, as the laggard Nasdaq finished closer to the session's low.

Though the extent of yesterday's pullback was relatively mild, especially for the S&P and Dow, it's negative that the retracement occurred on higher turnover. Total volume in the NYSE increased 11% above the previous day's level, while volume in the Nasdaq rose 14%. Lighter volume would have been better, as it would have indicated the bears were not anxious to sell into strength of the recent gain; lighter volume would have indicated the losses were more the result of the bulls taking a rest, rather than the bears aggressively selling. Still, declining volume in the NYSE only marginally exceeded advancing volume. The Nasdaq adv/dec volume ratio was negative by 5 to 1.

Though it may have disappointed investors that the S&P 500 finished nearly 5% below its intraday high, it's actually positive the stock market pulled back a bit. If the market tries to recover too much of its losses in such a short period of time, the gains are less likely to remain intact. Furthermore, a runaway market that's gapping 4% to 5% higher several mornings in a row provides minimal opportunities for low-risk entry points on the long side (just as last week's ferocious decline scarcely afforded low-risk short selling opportunities for those who missed the initial drop).

Going into yesterday's session, we were focused on the 20-period exponential moving averages on the hourly charts (20-EMA/60 min.) of the major indices. After the stock market proved it was able to retain its intraday gains through Monday's close, we were hoping the main stock market indexes would subsequently retrace down to new support of their 20-EMAs/60 min. As discussed several times over the past week, and also in my new book, Trading ETFs: Gaining An Edge With Technical Analysis, this moving average on the hourly chart interval frequently acts as a perfect indicator of short-term support or resistance. Since it acted as resistance on the way down, the 20-EMA/60 min. should now act as support as the market tries to move higher. Remember the most basic tenet of technical analysis; a prior level of resistance becomes the new level of support after the resistance is broken (and vice versa).

With one hour remaining in yesterday's session, all the major indices simultaneously fell to test new support of their 20-EMAs/60 min. We were pleased, as it provided us with an ideal buy entry into any of the broad-based ETFs. As such, we sent an Intraday Trade Alert to subscribers, informing them we were buying the Ultra Dow 30 ProShares (DDM). We chose the Dow over the other broad-based ETFs because it was showing the most relative strength at the time of entry. Our entry on the pullback to the 20-EMA/60 min., as well as the subsequent price action of DDM, is annotated on the chart below:



With a 2:56 pm ET entry price of $37.25, notice we did not buy the bottom of the day's range. Rather, we waited for DDM to dip below the 20-EMA/60 min., then show signs of successfully holding the test of support, before initiating our buy entry. Though stocks and ETFs will often bounce precisely off their 20-EMAs/60 min., it's equally common for issues to probe a few cents below the exact level of support before reversing. This has the added benefit of shaking out the "weak hands," which reduces overhead supply and adds to any subsequent buying pressure. Because DDM has been so volatile lately, we're already showing an unrealized gain of nearly 2 points on the trade; however, we also entered with reduced share size in order to accommodate a wider stop without additional risk.

In yesterday's newsletter, we said, "As the main stock market indexes consolidate or pull back in the coming days, sector ETFs with the most bullish divergence will be relatively easy to spot. ETFs that merely trade sideways, or even continue higher, when the broad market takes a rest will be those with the most relative strength. Those ETFs, of course, will be the ones we'll be looking to buy in anticipation of a short to intermediate-term rally." Yesterday, various financial ETFs clearly bucked the broad market weakness by zooming much higher, but their strength was primarily a news-driven event. Healthcare ETFs, such as XLV and IHE, also showed relative strength by gaining approximately 2%, while iShares Utilities (IDU) advanced 1.3%. But despite the early bullish divergence exhibited by these sectors, it is often deceiving to assess emerging trends of relative strength with just a one-day pullback in the broad market. We'll be closely scanning the entire market in the coming days, as we focus on detecting outperforming sectors that should lead the way higher in the short to intermediate-term.

The ability of the market to retain most of its October 13 gains over the next several days will be a determining factor as to whether that day's gains were a fluke, or the start of a substantial, tradeable bounce. It's definitely too early to predict whether we've seen the ultimate lows of the year-old bear market, but a short to intermediate-term counter-trend rally of at least 2 to 5 weeks is certainly a realistic expectation. Proceed with caution on the long side, buying pullbacks to support, while keeping share size in check. As for short selling, it's way too early to consider new entries right here, unless you're just daytrading intraday volatility. We'll close with a reminder to keep an eye on corporate earnings reports that start hitting the wires this week. Intuitive Surgical (ISRG), JPMorgan Chase (JPM), and Schlumberger (SLB) are some big names slated to report this week.

Open ETF positions:

Long - DDM, MOO, FXY
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.