Stocks recovered a majority of the previous day's losses last Friday, but firmly lower turnover failed to confirm the bullish reversal. The Nasdaq Composite bounced 1.1%, the S&P 500 1.0%, and the Dow Jones Industrial Average 0.8%. The small-cap Russell 2000 gained 1.3% and the S&P Midcap 400 rallied 0.9%. A moderate surge in the final thirty minutes enabled all the major indices to finish at their intraday highs.

Although the stock market once again demonstrated its resilience last Friday, it was negative that the gains occurred on significantly lighter volume. Total volume in the Nasdaq fell 23%, while volume in the NYSE came in 8% below the previous day's level. Just one session of lower volume gains would not have been a big deal, except that the Nasdaq also declined on higher volume the previous day. That pattern over the past two days tells us institutions were behind the selling last Thursday, but they backed away when stocks bounced the following day. Since volume changes usually precede price action, the negative pattern in the Nasdaq over the past two days is noteworthy. The NYSE fared better because Friday's lighter volume gains were also preceded by lower volume losses the previous day.

The real action last Friday was in Chinese stocks, as a rally followed reports that China may begin loosening price restrictions on refined oil and associated products. Not only did many leading Chinese ADRs break out, but they did so on strong volume. The iShares Xinhua China 25 Index (FXI) led the entire ETF market with a 5.5% gain. More importantly, turnover also surged to nearly 500% greater than its 50-day average volume. As you can see on the daily chart below, the rally in FXI also coincided with a breakout above key horizontal price resistance:



FXI closed just shy of its all-time high that was set on January 3 of this year. Expect a test of that resistance level in the coming days. In addition to FXI, there are three other ETFs directly tied to China. They are: PowerShares Golden Dragon Halter USX China (PGJ), StreetTRACKS S&P China SPDR (GXC), and iShares Hong Kong (EWH). All three posted similar gains as FXI, though EWH is tied to Hong Kong instead of mainland China. In the May 10 issue of The Wagner Daily, we illustrated the bullish chart pattern in EWH, so it was nice to sell the follow-through two days later:



In last Friday's newsletter, we said of the Nasdaq's close below its 20-day exponential moving average that, "a one-day probe below key support levels is never enough to confirm a reversal. In a strong market, stocks and indexes frequently dip below closely-watched support levels for a day or two, only to snap back after the "weak hands" have been shaken out at the lows." Given the overly bullish sentiment of the market lately, it was not surprising that the Nasdaq moved back above its 20-day EMA on Friday:



Obviously, it's positive that the Nasdaq bounced off its 20-day EMA into the end of the week. However, the negative price to volume relationship over the past two days has failed to confirm the bullish reversal. The desired confirmation would have come from lighter volume in Thursday's sell-off, followed by higher volume in Friday's rally. Instead, the Nasdaq had the opposite pattern of a higher volume "distribution day" on Thursday, followed by lower volume gains on Friday. While this certainly does not mean the Nasdaq is going to drop this week, it does provide a sound reason for astute traders to exercise a bit of caution with new long entries.

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.