Corrections, but No Reversals

01/21/2010 10:21 am EST

Focus: MARKETS

Lawrence McMillan

Founder and President, McMillan Analysis Corporation

Lawrence McMillan, editor of the Option Strategist, expects to see the market’s bullish trend continue, although not without some bumps in the road.

The end of 2009 and beginning of 2010 have been marked by a slow-motion, plodding rally that has carried prices to new post-March highs while volatility has plunged. The Standard & Poor’s 500 (SPX) chart remains positive in that it is above the trend line from the March bottom.

Near-term support exists as 1,130 and then at 1,115—the low of the last-day selloff of 2009. The chart would only turn negative if the trend line were broken and support at 1,100 were violated as well.

The equity-only put-call ratios have hopefully shrugged off the effects of the heavy hedging activity of last summer and resumed being useful indicators. They remain on buy signals, although they are very low on their charts, which makes them overbought.

There has been extremely heavy call option activity for over a week now. These volume surges appear periodically. The last one was last August, and when it ended, SPX fell about 40 points in three or four days. We would expect something similar to occur again now. Moreover, this activity has created a rather large number of put-call ratio overbought conditions and/or sell signals.

Market breadth has been strong since the beginning of the year, pushing the breadth oscillators into overbought territory. That is positive news in that it indicates the rally remains strong among a lot of issues.

However, the overbought condition also indicates that sharp, but short-lived corrections are possible at any time. Volatility indices (VIX and VXO) have continued to decline, and that is bullish. The down trend since mid-December is most noticeable on the VIX chart, and as long as that remains intact, the implications are bullish.

With VIX below 20, one would have to say it’s an overbought condition, though, but unless VIX begins to trend upward, it won’t be on a sell signal. VIX futures continue to trade with high premiums and with an upward slope to their term structure.

These are reflective of the bullish trend, and as long as they continue to exist, the market should be able to move higher. It would be a sell signal if the term structure were to invert and slope downward, while the futures all traded at discounts to VIX. That condition is unlikely to take place soon.

In summary, the conditions for a further rise in prices remain intact. None of the indicators are on sell signals, although overbought conditions warn of potential short-term corrections.

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