Overbought and None Too Worried

10/25/2010 11:26 am EST

Focus: MARKETS

Lawrence McMillan

Founder and President, McMillan Analysis Corporation

Lawrence McMillan, editor of The Option Strategist, says the overheated market has built up too much momentum to doubt eventual upside.

The market, as measured by the Standard & Poor’s 500, broke out to upside on October 5th, and has continually added to its gains since then. That breakout turned the intermediate-term indicators bullish, and they mostly remain in that state. There are some bothersome overbought conditions, but upside momentum remains strong at this time.

The S&P 500 chart is in a strong uptrend, with prices crawling along at a steady pace, and the 20-day moving average rising below them as support. The 20-day moving average is at about 1150 right now, which is the top end of the 1130-1150 price support on the chart. As long as the index remains above that level, the chart is positive.

As for resistance, the S&P 500 is now bumping up against the April topping area of 1180-1220. Considering the overbought conditions that are in place, this might a logical place for a short-term correction to take place.

The equity-only put-call ratios were the first indicators to turn bullish—a little over a month ago. Now, the standard ratio is the first one to turn bearish, although the weighted ratio remains solidly on a buy signal. So far, this is the only intermediate-term indicator to falter.

Market breadth indicators are extremely overbought now, after the strong move since the upside breakout over 1150 occurred. Both breadth oscillators, while on buy signals, are deeply overbought at near +500. Levels such as those typically generate at least a sharp, but possibly short-lived sell signal.

Volatility indices [the CBOE’S VIX and VXO, tracking volatility expectations from call and put options on the S&P 500 and the S&P 100, respectively—Editor.) were reluctant to break down during most of the month of September. The VIX had initially been near 21 when the S&P 500 was at about 1100 or so. The S&P 500 then rallied strongly, but VIX refused to confirm a similar move by breaking down. Finally, though, VIX did collapse below 21, and traded down to just below 18 [last] week.

The VIX has [since] risen, so there is still a certain amount of divergence. But the VIX would have to climb back over 21, as a first step, if it is to turn bearish. VIX futures continue to display the characteristics of a bullish but overbought market. The premium on the futures is large, and the term structure is sloped steeply upward. This pattern has already persisted longer than any similar one in history. But, unless the S&P 500 actually breaks down, the warnings of the term structure will be meaningless.

In summary, the intermediate-term indicators remain bullish. However, resistance at 1180-1220 coupled with an overbought condition will probably cause some short-term pullbacks. It would be somewhat disappointing to see another trading range set up, but that is highly possible due to the strong support at 1130-1150 and the afore-mentioned resistance at 1180-1220.

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