The Market Is Looking for Direction

06/28/2007 12:00 am EST

Focus:

Lawrence McMillan

Founder and President, McMillan Analysis Corporation

Lawrence G. McMillan, editor of the Option Strategist, says stocks are stuck within a trading range but remain very volatile as they await a breakout or breakdown.

The stock market remains very volatile, within what is now developing as a trading range.

Clearly the top of the range is 1535-1540, which the Standard & Poor's 500 has probed at least seven times in the past month-without being able to punch on through. There is some debate as to where the bottom of the range is, but it's somewhere between 1490 (the early June lows) and 1505 (where it closed Wednesday-Editor).

In either case, both bulls and bears have thought they had the upper hand, only to see the market reverse and head the other way. This back-and-forth action increases actual (statistical) volatility, without really giving any particular market direction. Eventually, a breakout will occur-either above 1540 or below 1490-and then a more trending environment may unfold.

The equity-only put-call ratios have been low on their charts for some time, indicating that they are in overbought territory. There have been a couple of sell signals, but the averages continue to "wiggle" at low levels, as the market flips back and forth.

But unless these ratios break down to new lows (which is a possibility, of course), we will continue to view them as bearish. In the bigger picture, they are telling us that a huge number of call options (versus put options) has been traded (purchased?), and this is a generally dangerous situation for the intermediate-term health of the broad stock market.

Meanwhile, despite the market advance last Thursday, market breadth (advances minus declines) was only modestly positive. Hence these indicators-which we prefer to view only as confirming indicators-are bearish.

Finally, there are the volatility indices ($VIX and $VXO). Early in the week, $VIX fell back below 14, completing a buy signal. That buy signal may have trouble sustaining itself, though, as $VIX jumped higher [again] and remains well above 14.  A new up trend in $VIX would be regarded as bearish. (It closed just below 19 on Tuesday, but plummeted 18% Wednesday to 15.50-Editor.) 

The volatility futures are all trading at a premium to $VIX, and that is a mildly bearish sign as long as $VIX is rising. Also, since the actual volatility of the S&P 500 has increased-due to volatile movements in both directions-$VIX should naturally trade at somewhat higher levels, just to keep pace.

In summary, the indicators are a bit mixed, as you might expect since the market is in a volatile trading range. Breadth and $VIX flip back and forth quickly as the market makes each volatile move. Even the more intermediate-term equity-only ratios have had trouble sustaining a signal. This is rather unnerving, but is probably to be expected during a trading range.

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