Hurdles the Market Must Clear

05/26/2009 12:00 pm EST

Focus: MARKETS

Lawrence McMillan

Founder and President, McMillan Analysis Corporation

Lawrence McMillan, editor of The Option Strategist, says the market is in a trading range, but some key indicators have put out sell signals.

The rally that began in early March carried the Standard & Poor’s 500 index ($SPX) back to nearly where it started this year—at 940. Those January highs represent resistance for the index now, as do the October highs at 1000.

In addition to running into resistance at 940, there is another widely-watched moving average that is somewhat problematic–the 200-day moving average of $SPX. A long-term moving average such as this usually defines the major trend of a market, and it is still declining. Moreover, it’s at about 950 right now, so that’s a further obstacle at that level.

In the short term, the chart of $SPX is bullish. The series of higher highs and higher lows is intact, and the 20-day moving average is rising. The resistance at 930-940 is visible, [and] there is support at 870-875, from where the market topped out in late January, early February, and—temporarily—mid-April. If that level were violated on the down side, it would turn the $SPX chart negative. Conversely, as long as $SPX stays above that level, the bullish case is still dominant.

Equity-only put-call ratios have taken on a more negative picture as well. The standard ratio has generated a sell signal, [but] the weighted ratio has not yet confirmed a sell signal. The weighted ratio of QQQQ (the Nasdaq 100 index) has also given a sell signal. The market can undergo sideways to slightly down movement when correcting overbought conditions, while the equity-only put-call ratios are on sell signals. That could be happening again, but in any case, it’s difficult for the market to generate substantial gains when this important intermediate-term indicator is on a sell signal.

Market breadth indicators have finally retreated from their near-historic overbought condition, and they too have generated sell signals. Previously, near the end of March, these breadth indicators moved to sell signals, but they were quickly reversed. This time, it seems that they might have more sticking power.

Volatility indices ($VIX and $VXO) continue to decline, and that is bullish. $VIX is in a clear down trend, and has been for some time. Its path mirrors that of the actual 20-day historical volatility of $SPX, which is now under 30. $VIX will maintain a bullish posture unless it closes above its declining moving average—currently at about the 36 level. Recently, however, the $VIX futures traded at a premium to $VIX, and thus issued sell signals. Those are sometimes early, but they are in effect now.

In summary, $SPX is likely trapped in a trading range between 870 and 940. A breakout from that range should be played with an aggressive position.

Subscribe to The Option Strategist here…

Related Articles on MARKETS