Is the Rally Running Out of Steam?

07/19/2010 12:30 pm EST

Focus: MARKETS

Lawrence McMillan

Founder and President, McMillan Analysis Corporation

Lawrence McMillan, editor of the Option Advisor, says we’ve seen a powerful oversold rally, but it may not have much more room to run.

The selling that began on Monday morning, June 21st, continued pretty much unabated for more than two weeks. In so doing, a rather severe oversold condition was created, and the market got a superb relief rally from that.

The chart of the Standard & Poor’s 500 Index is clearly in a down trend. Furthermore, it finally broke down through support at 1040 [a couple of weeks ago], before finding support near 1020—the lows of last October. By that time, it was quite a ways below its 20-day moving average (near 1075), and that is one indication of an oversold condition.

This oversold rally should be able to move to levels slightly above 1075. There is further resistance in the 1100-1120 area.

Market breadth indicators had turned decidedly negative and became extremely oversold during the two-week period of selling. We differentiate between "stocks only" breadth and New York Stock Exchange breadth. "Stocks only" breadth was far, far worse than NYSE breadth.

Part of the reason for that is that NYSE data includes many interest-rate-related issues, and those types of issues have generally been rising in price as the broad market has fallen. [Recently,] the NYSE-based oscillator rolled over to a Buy signal, and the “stocks only” followed suit today.

Volatility indices (VIX and VXO) have been among the most bullish indicators of late. When the market started to fall, breaking down below support at 1040, VIX rallied at first. But then it topped out at 37 [recently], closing that day below 32. That much of an intraday reversal is a spike peak Buy.

By closing below 30, the VIX chart is no longer negative for stocks. In general, VIX appears to be in a wide range between 23 and 37.

The failure [of the S&P 500] to hold the 1105 support area was very significant. At this time, 1020 is support and 1080 is resistance (forget the 1040 level; it’s been crossed and re-crossed, and therefore it’s relatively meaningless now.)

The market has not followed through on the last two breakouts (above 1105 in late June, and below 1040 in early July).

It has been better strategy to buy when the market is very oversold and to sell when it is overbought, or when it exceeds a technical level on a reversal (falling below 1105, or rising about 1040). A potential setup to watch for would be a close above 1080, and then a breakdown back below it. That would be bearish, and aggressive accounts could buy puts if that happened.

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