Bulls Hang On By Their Paws

06/02/2008 12:00 am EST

Focus: MARKETS

Lawrence McMillan

Founder and President, McMillan Analysis Corporation

Lawrence McMillan, editor of the Option Strategist, says the recent rally is weakening and the market needs to post stronger gains to show the bulls are still in control.

The upside breakout may be in jeopardy, but bearish signals haven't been confirmed.

The [recent] rally culminated with the Standard & Poor's 500 index ($SPX) reaching 1440 [intraday on May 19th.] Since then, selling has been in vogue. That broke the 20-day moving average and violated the 1400 support level, but it did not break the rising trend line from the March bottoms. That trend line is at 1390 currently (it closed below that level for two consecutive days on either side of the Memorial Day holiday-Editor), and there is previous support at that level as well, so that is the area we must watch.

The equity-only put-call ratios have been on Buy signals since the March bottom, but they are now wavering. Both ratios have curled upward. If they truly roll over and begin to rise, that is a sell signal.

In addition, the weighted QQQQ (Nasdaq 100) put-call ratio has also given a sell signal.  This is certainly bearish, but-in fairness-it should be pointed out that sometimes these put-call ratio sell signals don't take effect immediately; they might give a repeat signal (last October was a good example). Still, when and if the standard ratio's sell signal arrives, that should signal the next leg of the bear market.

Market breadth has been rather poor all along, and both breadth oscillators gave sell signals early this week. By itself, breadth has not been a particularly reliable leading indicator, so we have generally considered it merely a confirming indicator.

The volatility indices have-like $SPX and the put-call ratios-been in a clear bullish (down) trend since mid-March. That trend continues in $VIX. Its moderate rise early this week did not violate that trend line; it merely rose to the 20-day moving average. By our reckoning, $VIX would have to close above 19 at least-and preferably above 20-in order for this indicator to be declared as bearish-meaning that its down trend was broken.

The $VIX derivatives remain in a bearish setup mode, but haven't actually moved to bearish status. The premium on the June and July $VIX futures is huge, and the term structure of the $VIX futures shows a steep drop towards the front months. If that term structure starts to flatten out, a sell signal would be issued for the broad market. So far, it hasn't happened.

In summary, the bulls are still in position to keep this rally going, but they are running out of time. A decisive close below 1390 by $SPX, coupled with a rise in $VIX, and a confirmed sell signal in the standard equity-only put-call ratio would likely launch a new bear market leg.

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