Waiting for a Sharp Correction

03/22/2010 12:30 pm EST

Focus: MARKETS

Lawrence McMillan

Founder and President, McMillan Analysis Corporation

Lawrence McMillan, editor of The Option Strategist, says the market is way overbought, and he thinks a nice correction is imminent.

[Last month], we stated that [any close of the Standard & Poor’s 500]  above 1110 would be short-term bullish...and it has been. (The S&P 500 closed as high as 1166 before losing ground Friday—Editor.)

So, is this a new breakout? Not in our opinion, it isn’t. If you’ll recall, back in January, traders were looking for confirmation of a new breakout (the previous high had been 1148 and change, and several daily highs had probed slightly above 1150).

[A week ago, the S&P had] been up eight out of ten days, and advances have led declines ten days in a row. March S&P futures [were] up ten days in a row, too, which is supposedly a record. These are all signs of a massive short-term overbought condition, not to mention the VIX futures term structure.

The market can be a cruel taskmaster, and perhaps it would suck in the last shorts and convert some sideline money with a slightly higher close. Then a turnaround—making that a false breakout—would be extremely frustrating to most. Equity-only put-call ratios remain solidly on Buy signals, and they are not particularly overbought as they are more or less in the middle of their recent ranges.

However, market breadth indicators are very overbought. Both breadth oscillators were above +700, which is near historical levels. It is already surprising to me that the market has been able to forego a correction while these breadth measures are this overbought, but this is a situation that will surely result in at least a sharp, but short-lived, correction—probably in the area of 40 S&P points.

Volatility indices continue to decline, and that is bullish for stocks. Some are saying that VIX is “too low,” but that may not be true. What is “too low” is the actual volatility of the S&P, where the 20-day historical volatility is nearly down to an astounding 10%. This is clearly a market environment that sees only positive things. It has already persisted for longer than many thought, but that’s what Keynes was talking about [when he said the market can stay irrational longer than you can stay solvent].

Another nagging problem is the low volume (not in options, but in stocks). While we don’t necessarily consider that a sell signal, it does signify that volume is likely to explode on a market decline. We expect to see the usual activity when the first serious down day unfolds: Everyone will try to squeeze out the exit at once, and there won’t be room.

That’s how a 40-point correction can develop in just a couple of days. If the overbought condition had been worked off along the way with a few down days, we wouldn’t have reached this extremely overbought state, but it wasn’t, and so here we are.

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