Bullish, But a Little Extended

08/17/2009 10:46 am EST

Focus: MARKETS

Lawrence McMillan

Founder and President, McMillan Analysis Corporation

Lawrence McMillan, editor of the Option Strategist, says the market remains in a bullish trend, but there are some signs it’s a little overbought and needing a correction.

The Standard & Poor’s 500 index (SPX) has continued to rise in a very bullish fashion. This rally is apparently being fueled by institutional traders who hold too much cash. Short covering—another factor that boosts a rising market—is essentially nonexistent as the number of unhedged shorts has diminished greatly.

The SPX chart is bullish in that it is clearly in an up trend, and the moving averages are all rising now (even the 200-day moving average, barely). However, $SPX had recently risen to heights about 60 points above its 20-day moving average. That is “too high,” and is one indication of an overbought market. Hence a decline to the moving average might be beneficial in that it would relieve the overbought condition without harming the overall up trend.

The equity-only put-call ratios remain on buy signals, as those ratios continue to decline. They are near the lower regions on their charts, but that doesn’t mean that sell signals are imminent. Sell signals will occur if those averages roll over and begin to rise—not likely at the current time.

Market breadth oscillators are extremely overbought, even though there have been no “90% days” in the last three weeks. That is another indication of declining volatility. But the oscillators themselves both set new all-time highs recently. In the past, when the breadth oscillators hit all-time highs, there was a slight follow-through on the up side by the broad market, followed by a decline of 50 to 70 SPX points (or even more, in January 2009).

Volatility indices (VIX and VXO) continue to decline, and that is bullish. The VIX chart is probably the only indicator that is not overbought. VIX has risen a bit lately, so it is not at its lows (whereas SPX is at itshighs). This recent rise in VIX is being interpreted as a bearish sign by some, but the VIX chart won’t turn bearish until an up trend is in place, or at least until the down trend is broken. While there have been a couple of attempts to do that, they have been unsuccessful and so the bullish down trend remains in place.

Volatility futures are inflated, reflecting the consensus opinion that the market is going to be volatile. That consensus has become so uniform that we are beginning to doubt if it will actually come true. Meanwhile, the term structure of the futures is sloping sharply upward—as it is “supposed” to do in a bullish phase. This sharp slope is another indication of an overbought market.

In summary, our intermediate-term indicators remain on Buy signals, but the weight of the overbought evidence suggest that a sharp but short-lived correction is due.

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