Bears Are Running the Show

06/23/2011 9:30 am EST

Focus: MARKETS

Lawrence McMillan

Founder and President, McMillan Analysis Corporation

The technical indicators all point to an oversold market that could get a bit more oversold before it reverts to the mean, notes Lawrence McMillan of The Option Strategist.

Intermediate-term sell signals remain in effect, but this oversold rally could have a bit further to go.

The broad stock market has been under more selling pressure in the last four weeks than in the previous nine months. Intermediate-term indicators are all bearish at the current time, but after weeks of selling, some oversold conditions have arisen.

We’ll review both the intermediate-term and short-term conditions, by indicator.

First, consider the chart of the S&P 500 (SPX) itself. The bull-market trend line extending back to last August was broken and replaced by the current downtrend line. That makes the chart bearish.

The equity-only put-call ratios have remained on sell signals since mid-April. They are racing higher now, and by their sheer height might be considered a bit oversold. But they will remain bearish until they roll over and begin to trend downward.

The total put-call ratio, which is oversold, is setting up a major buy signal.

However, as long as the market trends lower, it is possible that the totalput-call ratio will continue to increase, thereby deferring the buy signal.

Breadth has been very negative. Both breadth oscillators have been on sell signals for some time, although the NYSE-based one has flirted with buy signals in the last couple of weeks.

The eventual result was major oversold indicators from both breadth oscillators. Rallies in the market will likely alleviate these oversold conditions to some extent.

The volatility measures that we follow are negative. The 20-day historical volatility of the S&P 500 has risen to 15%, from readings below 10%, and that is a sell signal.

Also, the Composite Implied Volatility (CIV) of all equity options had risen to the 25th percentile (currently 19th) from a low of 6th a month ago. That, too, is a sell signal.

At a strong, intermediate-term bottom (as we saw in March), all of the VIX futures would be trading at a discount. Thus, their penchant to retain premium now is actually a bit bearish, because it is reflecting a continued bullish complacency.

The same can be said of the term structure, which continues to slope sharply upward.

In summary, the intermediate-term indicators are negative (with the possible exception of $VIX). The oversold conditions may propel a rally towards 1,325, but as long as $SPX is trending downward, the bears are in charge.

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