Ready to Confirm the Rally

09/27/2010 12:00 pm EST

Focus: MARKETS

Lawrence McMillan

Founder and President, McMillan Analysis Corporation

Larry McMillan, editor of The Option Strategist, likes September’s strong stock rally, but is waiting to see volatility drop decisively before he gives the edge to the bulls again.

Oversold conditions that existed at the end of August, coupled with some massive reallocation into stocks and out of bonds, launched the broad stock market into a strong September rally. As soon as the calendar changed from August to September, strong buying began, and it hasn’t really let up since.

There [have been only two] significant down days in September so far. This has confounded “conventional” wisdom that expected September to be a bearish month. It still could be, though, for the end of September is usually the most bearish part, according to The Hirsch Organization.

The Standard & Poor’s 500 index has now risen [above] 1,130—the level that repelled rallies in both mid-June and early August. Both of those tops were false breakouts of a sort, as 1,120 was perceived to be a resistance level at the time.

The reason we are suspicious of a breakout is that there are some extremely overbought conditions, and there are some divergences beginning to appear. Market breadth oscillators are

on Buy signals, but are very overbought. Also, breadth has been negative on two recent days, even though the major indices rallied back late in the day.

But perhaps the most extreme overbought condition is in the term structure of the VIX futures (a measure of the market’s volatility—Editor). There are very large premiums on the VIX futures, and their prices are aligned such that there is a steep upward slope from one month to the next. That is, the “term structure” is very steep.

While that reflects an ongoing bullish market, it is also an overbought condition. The last three times that the term structure approached levels this steep, sharp market corrections followed—with the S&P dropping from 50 to 200 points.

The intermediate term indicators are more constructive. Equity-only put-call ratios have both rolled over to Buy signals recently. Volatility indices are in down trends, so that is bullish as well. VIX has been in its own trading range—roughly from 21 to 29, as the lower end of the range was pushed downward slightly.

If the S&P breaks out over 1,130 and the VIX simultaneously falls convincingly below 21, that would be a positive confirmation. But if VIX doesn’t follow through, even though the S&P trades above 1,130, it would be another warning indicator.

(The S&P rallied sharply Friday, closing at 1148.67, with big spreads between advancing and declining issues, up volume and down volume, and new highs and new lows. The VIX fell 9%, but still closed over 21, according to Bloomberg.com—Editor.)

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