Deeply Oversold, But Still a Bear

07/21/2008 12:00 am EST

Focus: MARKETS

Lawrence McMillan

Founder and President, McMillan Analysis Corporation

Lawrence McMillan, editor of the Option Strategist, says we’re in a deep bear market, but stocks are set up for a bounce of the kind we may have experienced last week.

One of the nastiest bear markets in memory continues to grind its way lower. Even though the market—by many measures—has been very oversold for some time, it keeps going lower. That is typical of bear markets at their strongest. Rallies have been short-lived, followed quickly by more selling.

Significant support at 1270 [on the Standard & Poor’s 500 index] was violated, and new closing and intraday lows have been made [before the recent rebound]. That area represents the first level of resistance, while 1235 is support as it has been tested three times and has held. Any move outside of the range 1235-1280 would likely be significant. (It closed below 1215 on July 15th and bounced back to close Friday above 1260—Editor.)

The S&P’s chart remains a very negative one. The 20-day moving average is declining, although it’s well above current prices—at about 1305 or so. This is one demonstration of how oversold the market still is. What would it take to turn it positive? A true base-building process, establishing higher highs and higher lows. That would take a while.

The equity-only put-call ratios remain on sell signals. Neither ratio has reached extreme oversold levels (heights) yet, so there appears to be more selling to come before these roll over and give new buy signals.

Market breadth is extremely oversold. The stocks-only oscillator dropped to nearly -800, the lowest it’s been since July 2002. The NYSE-based oscillator also approached -800, its lowest level since March of 2003. Clearly these are extremely oversold levels, and they are thus the main harbinger of an oversold rally (which may have begun last week—Editor).

Volatility indices ($VIX and $VXO) continue to rise, and so they remain in bearish up trends. However, they haven’t formed the spike peaks that have generally accompanied market bottoms in the past. In our opinion, the bears will be in control unless traders panic and buy puts, forcing $VIX to spike upward.

Is a spike peak in $VIX mandatory for a bottom? No, nothing is ever mandatory—one must “listen” to the market. But without a capitulation panic, we would expect that any rallies would not be very long lasting.

In summary, we remain negative, but mindful of the fact that oversold rallies could spring up. Breadth is potentially oversold enough to denote a major bottom, but none of the other indicators are. However, rallies have been meek, so bears should retain positions as long as the S&P remains below 1280.

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