When Low Volatility Goes on and on

04/19/2010 10:42 am EST

Focus: MARKETS

Lawrence McMillan

Founder and President, McMillan Analysis Corporation

Lawrence McMillan, editor of the Option Strategist, says the market’s low volatility is rare, but it’s happened before, and can signal a correction ahead.

Very little changes from day to day, or even from week to week, when describing this market. It continues in a bullish, steady advance, with very mild corrections, and little change in the status of most indicators.

[The Standard & Poor’s 500 index has been] climbing while staying well above its 20-day moving average. It hasn’t even touched that moving average since late February. That makes it short-term overbought.

However, the trend of [the S&P 500] and the fact that it—and many other major averages— recently made new highs together are intermediate-term bullish indicators. The equity-only put-call ratios have continued to decline. Market breadth remains very strong. Both breadth oscillators have remained in overbought territory since February 16th. Obviously, the market can advance while breadth is overbought. It would take at least two strong days of negative breadth to roll these indicators over to sell signals now.

Volatility indices (VIX and VXO) have continued to decline (until Friday’s spike after the market sell off following the SEC’s action against Goldman Sachs Group—Editor). The fact that these volatility indices [have been] in down trends is another intermediate-term bullish indicator.

So, the market is strong and bullish from an intermediate-term viewpoint, but it is flashing overbought conditions in a number of areas. The rise since the February lows has already maintained overbought conditions in breadth and VIX futures that are rarely seen.

The slow crawl upward with ever-dropping actual (historical) volatility is beginning to resemble the last few months of 2006, when volatility was extremely low, and there wasn’t a correction of even 1% for months on end. At that time, the 100-day historical dropped to 7%. Even VIX dropped below 10% several times during that period.

Eventually, the S&P dropped 50 points (3.4%) in one day in February 2007, on a Chinese threat to raise margin requirements. One can never anticipate news like that, but it does show the risk in a market that refuses to correct.

Prior to that, volatility was low for long periods of time in 1993, 1994, and 1995. The most extreme lows were reached in the summer of 1995, as the stock market crawled steadily higher from February through December, 1995.

I think the point that we can draw from these past periods of low volatility is that they can last for a long time. They also generally accompany a bull market, although that was not the case in 1994.

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