Is This Rally for Real?

02/04/2008 12:00 am EST

Focus: MARKETS

Lawrence McMillan

Founder and President, McMillan Analysis Corporation

Larry McMillan, editor of the Option Strategist, says the current rally may be a rebound by an oversold market, but stocks may eventually retest the lows.

It should not be news to any serious trader that this market was deeply oversold, prior to Wednesday [January 23rd]’s reversal rally. With that reversal, many traders have now turned bullish. But are they correct in their bullishness?

The entire mood of the market changed with the upward reversal on [that] Wednesday. As I watched the market trade that day, it certainly seemed as if there was a forced seller (e.g., a margin liquidation) of a large account. Once that selling was out of the way, the market lifted. Now, it appears that the selling might well have been the error account at Societe Generale, liquidating the rogue trader’s positions.

In any case, the market had reached oversold levels of nearly historic proportions and thus was primed to rally–which it has, and should continue to do so, at least for a while. The Standard & Poor’s 500 ($SPX) now has support at the Tuesday and Wednesday bottoms, at 1270-1275.

On the other hand, there is resistance at 1365-1370—the area from which [the index] broke down [the previous] week. With a market as volatile as this one, support and resistance levels need to be drawn on the charts with crayons, for they are not exact.

Market breadth has not been overwhelmingly strong on this rally. So the “stocks only” breadth oscillator hasn’t given a textbook buy signal. Meanwhile, the less reliable New York Stock Exchange (NYSE) breadth oscillator has given a buy signal.

In my opinion, this rally is strictly the result of the massive oversold condition. Or, if you prefer, everyone who wanted to sell had sold. It has less to do with the news that CNBC and other media outlets try to conjure up to justify a suddenly-strong market. Does this rally mean "the" bottom is in? I don't think so, but it certainly means "a" bottom is in–and should last for a while.

However, the larger picture is not so positive. There was major damage done, and most stocks are going to need time to build bases. No matter where this rally takes us, we expect to see that support level tested again in the coming weeks or months. If we’re in a continuing bear market, that retest may well fail.

It’s possible that the market’s movement might follow the pattern of a large trading range between $SPX resistance (1370) and support (1270). Of course, that’s what seemed to be going on last fall–between 1410 and 1560–before the breakdown came.

Regardless, we expect volatility to remain high. The longest-term volatility futures are trading near 24%. That’s a far cry from having volatility in the 10%-14% range, as was the case for most of 2005 through 2007. So, enjoy this rally while it lasts, but expect continued volatility.

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