The Rally Doesn’t Have Legs

02/22/2010 10:55 am EST

Focus: MARKETS

Lawrence McMillan

Founder and President, McMillan Analysis Corporation

Lawrence McMillan, editor of The Option Strategist, says the recent rally has weak underpinnings, and he expects the market to head back down.

The chart of [the Standard & Poor’s 500 index] now clearly shows lower highs and lower lows. That is an intermediate-term bearish pattern.

The breakdown below support at 1085 finally occurred almost [three] weeks ago, leading to the down trend that is now in place.

An oversold rally has sprung up, and it could carry to resistance [above] 1085-1100, an area also bolstered by the presence of the now-declining 20-day moving average.

Equity-only put-call ratios are on intermediate-term sell signals as well. These sell signals came from very low levels on the chart, which often means they are particularly strong. So far, they have been.

Market breadth deteriorated badly during the decline from mid-January. There was finally a 90% down day [a couple of weeks ago]. As a result, both breadth oscillators became deeply oversold. It is primarily this oversold condition that spurred the rally.

It is often the case that when the breadth oscillators become deeply oversold, sharp but short-lived rallies occur. Those oversold conditions have now been alleviated, and the breadth oscillators are on buy signals.

Volatility indices (VIX and VXO) served up a change of pace from their recent bull market patterns, by not making new lows after having spiked up in late January. As a result, VIX is now in an up trend, and that’s bearish for stocks. Only a close below 21 would turn the VIX chart back to bullish again. (It closed near 20 Friday—Editor.)

Volatility futures have been painting a less bearish picture. The futures themselves have remained at a premium to VIX for the most part, and the term structure continues to slope upward. Together, these form a bullish construct for the volatility futures. A negative signal would occur if VIX began to trade at a significant discount to the VIX futures, and the term structure were to slope downward.

In summary, there are intermediate-term sell signals from the [Standard & Poor’s 500] chart, the VIX chart, and the equity-only put/call ratios. The reflex oversold rally that has taken place [recently] is a bit “stickier” than usual, but it should have trouble with overhead resistance just above current levels.

The comparisons between the 1938-1939 markets and those of today, 2009-2010, continue to correlate very strongly. In 1939, the first decline was a 10% decline. This year, the decline started a bit later, and has only reached about 7% so far, but could eventually extend to 10%.

In 1939, the market rallied during February before collapsing to an interim low in April The total decline was 20%.

During the February 1939 rally, volatility dropped back to its low. For the remainder of the summer, however, volatility in 1939 hovered just below 20. Knowing what we do today about how VIX behaves, we could project that VIX will spend a great deal of the next few months in the low 20s, if 1939 volatility is a guide for 2010.

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