Will the Retest Hold?

06/23/2008 12:00 am EST

Focus: MARKETS

Lawrence McMillan

Founder and President, McMillan Analysis Corporation

Lawrence McMillan, editor of the Option Strategist, says the markets are full of bearish signs, and we may be close to a retest of the March lows.

The breakdown through several support levels by the Standard & Poor’s 500 ($SPX) has ushered in some very negative market action—likely setting in motion the next downward leg of the bear market.

Things have really accelerated [since] the breaking of the 1370 level. That area now represents major resistance, with several other levels above it. As for support, there may be some near the April lows at 1325-1330, [although it closed below 1318 Friday—Editor.]

The equity-only put-call ratios have remained steadily on the sell signals that they first generated about [one month] ago. They are still relatively low on their charts and likely have a long way to rise while still on these sell signals. As long as they are rising, that is bearish for the broad stock market. Market breadth has been abysmal on this decline, and as a result both breadth oscillators are in oversold territory.

The volatility indices have established up trends, and that is bearish. The confirmation of this $VIX sell signal came [a couple of weeks ago] when $VIX spurted substantially higher as the market dropped. That established a pattern of higher highs and higher lows for $VIX, which defines an up trend. As long as $VIX remains in this up trend, it is bearish for the broad market.

The $VIX derivatives have moved from an “overbought” condition to a neutral status. That move generated sell signals based mostly on the term structure of the futures. At the current time, these volatility derivatives are more or less neutral. However, their momentum is in the bearish direction, and we would expect to see that continue.

In summary, we have no buy signals from our indicators. However, we do have oversold conditions, as noted by market breadth and also a recent “90% down day.” Thus a short-lived and potentially powerful rally could spring up at any time. We think any such rallies should be sold, especially if $SPX approaches the 1370 level, which is the area of major resistance.

We think that this new down leg is strong enough that it will have to be resolved with a typical capitulation low–involving a spike peak in $VIX and put-call ratio Buy signals near the top of their charts. By the time all that happens, it would not be surprising to see $SPX in the neighborhood of the March lows. If so, it will be interesting to see whether or not a “retest” holds.

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