Markets Need Time to Repair the Damage

03/07/2007 12:00 am EST

Focus:

Lawrence McMillan

Founder and President, McMillan Analysis Corporation

Lawrence McMillan, editor and publisher of the Option Strategist, assesses the impact of last week’s sell-off and lays out some signals that could prompt investors to buy again.

The landscape has changed dramatically in the last week: volatility has increased substantially and weeks, if not months, of gains in most stocks have been wiped out.  The question now becomes when and where will this decline end?  Since our technical indicators were instrumental in warning us of this decline, we are of course going to rely on them to aid us in answering that question.

We were looking for a sell-off, but we didn't know it would be this sharp, of course. The Standard & Poor’s 500 has broken most of the major support levels it had established in its inexorable, stair-step rise over the past several months.  But the index wiped out three months’ worth of gains in one day trading at the same price it had on December 1, 2006.

Many stocks fared even worse: Procter & Gamble, for example, wiped out nearly six months’ worth of gains in one day.  As far as the S&P 500 is concerned, the 1430 level is now resistance, much as it was during December and January.  Until that level is overcome, the S&P’s chart should be interpreted with a bearish bias. 
 
Market breadth (advances minus declines) had been running at very overbought levels for quite some time.  That is no longer the case.  In fact, last Tuesday (during the huge decline), declining optionable stocks outnumbered advancing optionable stocks by the largest ratio in history. Now, the breadth oscillators have generated sell signals. We are looking for breadth to get oversold--something it hasn't done for months--before generating buy signals.  That, too, isn't going to happen overnight.

Finally, there is the indicator that was perhaps most instrumental in our expectation of a correction: the volatility index, or VIX.  It had traded below 10, and history showed that a sharp correction normally takes place after that.  Now, VIX has spiked upward.  A buy signal occurs when VIX makes a spike peak on its chart.  The problem comes in defining what exactly constitutes a peak. 

Since VIX spiked above 19, we are (rather arbitrarily) defining a VIX close below 15 as a buy signal.  Thus, this is the only indicator that is close to a buy signal now.  But it has often proved to be a timely and significant one.  Hence, we would turn short-term bullish if VIX generates a buy signal.
    
A buy signal from VIX would be a positive short-term sign, but there has been major damage done to many accounts and buying is no longer on many [investors’] minds. So, we want to see more complete buy signals--such as the S&P 500 closing above 1430-- before we turn intermediate-term bullish.

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