Stock Rally Equal to the Test

03/07/2011 12:42 pm EST

Focus: MARKETS

Lawrence McMillan

Founder and President, McMillan Analysis Corporation

The quick rebound from recent weakness should reinforce the bullish trend, writes Lawrence McMillan, editor of The Option Strategist.

The market finally broke in late February, using the excuse of unrest in Libya, accompanied by sharply higher oil prices.

Short-term sell signals were invoked, including such items as the Daily Sentiment Index (DSI) falling below 90, the Composite Implied Volatility (CIV) of all equity options rising above the 16th percentile, and breadth oscillator sell signals.

Accordingly, the Standard & Poor’s 500 index fell about 50 points to the level of the bull-market trend line—the line connecting the August and November lows. That trend line is currently at about 1,297, which was violated briefly:

chart
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This decline to the uptrend line fulfills short-term correction objectives. The rally from there suggests the recent pullback has merely been an overbought correction that ran its course.

The most bullish intermediate-term indicator continues to be the price chart of the S&P 500. It is still bullish as long as that trend line remains intact.

Contrast this with the Chicago Board Options Exchange Market Volatility Index (VIX). It rose sharply as stocks fell, breaking through its trend line:

chart
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The other “streaks” that were in place have all ended: Fifteen days of consecutive price gains for the PowerShares QQQ Trust (Nasdaq: QQQQ) [a Nasdaq-100 proxy—Editor]; 12 days in which S&P futures closed higher than their open; nearly three months without the S&P 500 closing below its 20-day moving average; and so forth.

Market breadth has been weak, and the breadth oscillators have descended into sell signals. They are not oversold, though, so they would seem to indicate that there is more room to move on the downside before oversold conditions can arise to halt the decline.

VIX futures lost a lot of premium recently, and the term structure flattened somewhat as well. This is typical action in a bearish correction.

But the fact that the term structure continues to slope upward [the higher prices in more distant months implying expectations for more volatility in the future—Editor] means that it is still in a generally intermediate-term bullish mode. Only if the term structure were to invert would it actually be a bearish signal.

In summary, the intermediate-term indicators are mixed. On the bullish side are the S&P chart and the fact that the VIX futures term structure is still sloping upward. On the bearish side are sell signals from the VIX and from the breadth oscillators.

A breakdown and close by the S&P below 1,294 will turn the intermediate-term picture bearish, while a VIX close below 20 will make the intermediate-term picture bullish. [The S&P 500 was down to 1,310 in today’s downdraft, while the VIX jumped from 19 to 21—Editor.]

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