A nearly 4% plunge in the Semiconductor Index ($SOX) yesterday led to a sharp drop in the Nasdaq that followed the previous day's weakness. The Nasdaq Composite gapped down on the open, trended steadily lower throughout the day, then finished near its intraday low and with a 1.5% loss. The small-cap Russell 2000 similarly declined 1.3%, but the S&P and Dow showed firm resilience for the second consecutive day. The S&P 500 fell 0.3%, while the Dow Jones Industrial Average lost only 0.1%. The S&P Midcap 400 was lower by 0.9%.

Although the S&P 500 lost only 0.3%, a 6% volume increase in the NYSE generated a bearish "distribution day" for the S&P yesterday. Turnover in the Nasdaq was also 6% higher than the previous day's level, causing the Nasdaq to register its second straight "distribution day." Not surprisingly, market internals in the Nasdaq were firmly negative as well. Declining volume in the Nasdaq trounced advancing volume by a margin of more than 7 to 1. The NYSE ratio was only negative by 1.2 to 1.

Yesterday was the Nasdaq's third day of institutional selling within the past four weeks, which should serve as a warning to astute traders. As mentioned yesterday, uptrends can reverse in a fast and furious manner when an index sees four or more "distribution days" within a one-month period. Remember that institutional trading accounts for approximately two-thirds of the stock market's volume on any given day. Therefore, the market will always follow the trend of institutional trading activity. That's why we pay so much attention to the days in which the market rises or falls on higher volume. "Accumulation days" and "distribution days" are the footprints of institutional activity.

In yesterday's The Wagner Daily, we explained why a break below Wednesday's low in the $SOX would likely cause the index to rapidly drop down to its 200-day moving average. That is exactly what happened yesterday, but the collapse was even faster and more far reaching than we expected. The $SOX opened just below the previous day's low, then plummeted down to its 200-day moving average within the first thirty minutes. By day's end, the $SOX had shed 3.9% and closed well below its 200-day moving average. From December 1 through January 4, the $SOX tested and bounced off support of its 200-day MA in seven different sessions. The numerous bounces off its support demonstrated the importance of the 200-day MA as a pivotal support/resistance level, but each subsequent test increased the likelihood of an eventual breakdown.

When the $SOX broke out above its downtrend line on January 10, many traders (including yours truly) bought the semiconductors in anticipation of further upside. But a negative reaction to Intel's earnings report three days later killed the technical setup. This caused the bulls to be trapped, as traders who bought the strength were forced to sell a few days later. The resulting failed breakout from this selling attracted the attention of the short sellers, who further accelerated the decline. When it became apparent the $SOX was finally going to break support of its 200-day MA yesterday, the last batch of sellers was the the people who have been hanging on to their positions only because the $SOX was holding above its 200-MA. When it became apparent that a breakdown was imminent, those traders and investors "threw in the towel" as well. Fortunately, we realized only a small loss in our SMH position because we sold half of the position into strength on January 17, immediately after the negative Intel reaction, then dumped the rest on yesterday's open. Looking at the daily chart below, notice how rapidly the $SOX came unglued after failing to hold the low of its January 10 breakout:

Remember that technical analysis is nothing more than a way of charting human psychology and emotions. If you continually think about the reasons that traders are inclined to buy and sell, namely fear and greed, then you will understand why support and resistance levels work as well as they do. This is the reason why we explained the human factors that led to a breakdown in the $SOX, rather than just showing you the chart and telling you it lost support.

Needless to say, the Nasdaq's valiant start to the new year is now in jeopardy. The index closed well below the 2,470 support level that we illustrated yesterday, and is once again in danger of breaking below its 50-day MA. The Nasdaq Composite closed only 11 points above its 50-day MA, so keep an eye on that important level today. Downward momentum is likely to be substantial if the index breaks below that level today. So far, the Nasdaq is positioned for a classic failed breakout to a new high. Obviously, the S&P and Dow are holding up much better, but a breakdown in the Nasdaq would inevitably become a major drag on the other indices as well. Remember that the Nasdaq was the only one of the major indices that had broken out to a new six-year high, but now all the indices are back below their December highs (January 3 high for the Dow). The Russell 2000 also closed below its 50-day MA yesterday, which is a negative sign for the broad market as well.

If you've been heeding our warnings against aggressively trading during earnings season, you have probably averted substantial losses. But if you are still fully positioned, now is not the time to be a hero. Continue to tread lightly over the next few weeks because a shaky market is more susceptible to news, and there is plenty of that on tap!

Open ETF positions:

Short FXI, EEM (regular subscribers to The Wagner Daily receive detailed stop and target prices on open positions and detailed setup information on new ETF trade entry prices. Intraday e-mail alerts are also sent as needed.)

Deron Wagner is the head trader of Morpheus Capital Hedge Fund and founder of Morpheus Trading Group (morpheustrading.com), which he launched in 2001. Wagner appears on his best-selling video, Sector Trading Strategies (Marketplace Books, June 2002), and is co-author of both The Long-Term Day Trader (Career Press, April 2000) and The After-Hours Trader (McGraw Hill, August 2000). Past television appearances include CNBC, ABC, and Yahoo! FinanceVision. He is also a frequent guest speaker at various trading and financial conferences around the world. For a free trial to the full version of The Wagner Daily or to learn about Deron's other services, visit morpheustrading.com or send an e-mail to deron@morpheustrading.com .