Know When to Fold 'Em, Know When to Run

11/22/2010 1:00 pm EST

Focus: MARKETS

Lawrence McMillan

Founder and President, McMillan Analysis Corporation

Lawrence McMillan, editor of The Option Strategist, contends the trend is still stock buyers’ friend, until the volatility really spikes.

The Standard & Poor’s 500 index could not hold the attempted breakout over resistance at 1120 last week. It had moved up to that level in the euphoria on the day after Quantitative Easing 2 [the Federal Reserve’s latest bond-purchase program] went into effect. So far, the pullback from that level has been orderly—not even retreating to the rising 20-day moving average. Perhaps it’s just a normal reaction to an overbought condition. Perhaps it’s a bit of “sell on the news,” after the market more or less got what it wanted from the Fed.

But it pays to be wary, for we continue to think that the lessons of the 1930s could easily apply today. What happened in 1938 could be important: after the Republicans won a mid-term election victory, the market rallied strongly the next day. Then it declined, and never saw those post-election day levels again for seven years! Might we be saying the same thing about Nov. 4 and 5, 2010, years from now? Possibly.

The intermediate-term indicators are still bullish. The S&P is in a general uptrend, above support at 1180-1200, and above its rising 20-day moving average. The equity-only put-call ratios are both on buy signals again. As we have noted, the weighted ratio is the better measure at the current time, as it is less influenced by the heavy put buying of out-of-the-money puts for protection. Both ratios are bullish now, and not particularly overbought (i.e., they are not all that low on their charts).

Market breadth had reached extremely overbought levels after the news events of [early November]. They were so overbought that a modest market decline was warranted, and that is what we are seeing now. Even if these breadth oscillators were to turn negative, we’d want confirmation from some other source—for they gave false sell signals a couple of weeks ago.

Volatility indices (VIX and VXO) have generally continued to decline. A declining trend in volatility is bullish for stocks. Even with this current sell-off, VIX has not been able to climb above 19. It would have to rise above 22 in order to break its trend and thus turn bearish for stocks.

The VIX futures continue to trade with relatively large premiums, and their term structure remains quite steep. [In other words, investors are expecting options volatility to increase significantly in the longer run—Editor.] This has persisted so long (since July), that we can’t give it any credence as a timing vehicle. Rather, it is just a warning that the term structure will eventually have to flatten, and the likely way for that to happen will be for the market to decline.

Elsewhere in this letter, we discuss the other two major overbought conditions: 1) the actual volatility of the S&P 500 has fallen below 10%, and 2) the S&P has not even touched its 20-day moving average since September 1st. Actual volatility can remain low for long periods of time, but when it eventually begins to rise, a sell signal is generated. Furthermore, the last two declines (in January and May) started as soon as the S&P closed below its 20-day moving average.

Therefore, we think that the best course is to remain bullish in line with the intermediate-term indicators. But if actual 20-day historic volatility of the S&P rises above 13% and if S&P closes below its 20-day moving average, then it will time to turn bearish.

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