Sitting at the Crossroads

As we close the first week of November, the stock market is at a crossroads. The positive is that the major indices are bouncing off their recent lows, and have closed above their Nov. 4 highs, a day that finished on a rather negative note. However, there hasn't been a single day of higher volume gains -- no "accumulation days" -- since the bounce off the Nov. 2 lows began. As such, mutual funds, hedge funds and other institutions are apparently staying on the sidelines.

Given the current situation, many traders are probably wondering whether it's time to begin re-entering the long side of the market, in anticipation of a breakout to new 52-week highs ... or whether the present bounce off the Nov. 2 lows is merely a chance to enter new short positions with a positive reward-risk ratio. We're seeing some mixed signals, but the daily chart of the S&P 500 is now forming the right shoulder of a bearish head-and-shoulders top. I've noted the pattern on the daily chart of the S&P 500 Index below (moving averages are removed so you can more easily see the pattern):

S&P 500 Index -- Daily Source: TradeStation

If the head-and-shoulders pattern follows through, the next major move in the market will be to the downside. However, recall the major indices also formed the same pattern from May to July of this year but failed to follow through to the downside. Instead, the indices came into support of their "necklines" then promptly ripped to new highs. Obviously, this could happen again this time. But one major difference between now and then is that there has yet to be a solid day of accumulation. Almost without fail, significant market reversals from downside corrections are preceded by at least one day of higher-volume gains, which subsequently builds on itself.

Right now, the major indices are basically in no man's land, attempting to recover from their lows of the short-term correction but so far without conviction on the buy side. As such, it makes sense to be prepared on both sides of the market. It may be a good idea to maintain a watch list of potential buy candidates if the broad market suddenly surges higher, invalidating the head-and-shoulders pattern on strong volume. Conversely, now is the ideal time to have a list of a few possible short entries to consider if stocks run out of steam and start rolling over again.

---

At the time of publication, Wagner was long FAZ.

Deron Wagner is the founder and head trader of Morpheus Trading Group. His daily focus is managing and trading the Morpheus Capital Hedge Fund, which he founded in April of 2004. He also teaches his trading methodology with The Wagner Daily, The MTG Stalk Sheet, and The Wagner Weekly newsletters.