Still Waiting for Capitulation

03/16/2009 12:00 pm EST

Focus: MARKETS

Lawrence McMillan

Founder and President, McMillan Analysis Corporation

Lawrence McMillan, editor of The Option Strategist, doesn’t think the market has hit bottom yet, and he thinks we still need to see a spike in volatility before it does.

When the Standard & Poor’s 500 index broke down through the multiple support level at 805-810, it unleashed a torrent of selling.

The selling [wasn’t] all technical, of course, as the news out of Washington is being interpreted as so unfriendly to Wall Street that it’s poured fuel on the fire. The result is a deeply oversold market (in terms of breadth and other traditional technical indicators).

However, sentiment indicators have not followed suit. It’s unclear what has possessed so many traders to try to fight [the recent] decline—to bottom fish, to ignore breaking support levels, and to refuse to panic.

Regardless, it has now reached proportions where a washout will probably be needed to form a bottom—much as we had in November. That bottom was only an intermediate-term bottom and the next one may be, too. (Interviewed last week by MoneyShow.com, McMillan said he thought the market hadn’t hit bottom yet—Editor.)

[Recently the S&P was] trading well below its 20-day moving average, which makes it “oversold.” Oversold rallies often bounce up to the declining 20-day moving average, which is currently at about 780. There is also fairly heavy resistance in the 740-780 area. (It closed above 756 Friday—Editor.)

When the 740 level was breached on February 27th, that released the worst selling. Perhaps it came so swiftly that it caught traders by surprise, and that is why they haven’t turned to traditional protective methods in reaction.

One of those traditional methods would be to buy puts, but the equity-only put-call ratios are languishing near the middle of their charts. Traders have not felt the need to rush in and buy puts even as the market is disintegrating. That’s complacency!

Market breadth [has been] extremely oversold. Both breadth oscillators [have been] near historically low levels (although not as low as they were last November). There have been four “90% down days“ (and one “90% up day”). With breadth this oversold, sharp but short-lived rallies are to be expected. It would likely take about three days in which advances lead declines to generate buy signals from these breadth oscillators.

Volatility indices (VIX and VXO) reflect similar characteristics. Both are neutral—mired in trading ranges, and they have not spiked upwards in a show of panic as they always do. This is because traders have not seen the need to pay up for S&P 500 puts (whose premium “drives” the VIX calculation).

These declines usually end the same way—with traders finally panicking and VIX spiking higher. A spike peak in VIX would be a buy signal—something that has not been forthcoming.

In summary, expect large counter-trend rallies. But until we see some capitulation in the sentiment indicators, we don’t envision an intermediate-term bottom.

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