McMillan Market Commentary

The stock market was under some pressure entering this week, but a positive intraday reversal on Tuesday has stemmed the bearish tide, and may have turned things bullish once again. $SPX bottomed right near the longertem bull market trend line that connects the August, 2010, and March, 2011, bottoms. Such trendlines are often not reliable support, but it was this time. Also, $VIX spiked up to 19 on Tuesday, and that apparently was enough to trigger some buying as well. So, the bearish signals that were building up have been negated to a certain extent, but buy signals are not uniformly in place, either.

Hence, $SPX may be stuck in the 1320-1360 trading range until one side or the other can decide to make a sustained move. It has seemed to be the case since early April that the market gets quite overbought or quite oversold on what amounts to a rather small movement in $SPX. Then it reverses.

At this time, $SPX has now rallied back to about where its 20-day moving average is. There is still a downtrend in existence which is the most bearish thing about its current chart. A breakout of either trend line will likely lead to a more sustained move than we’ve seen in recent weeks.

The equity-only put-call ratios are in trading ranges as well. They gave appropriate sell signals at the end of April and since then they looking like dampening waves with each subsequent high or low. Like $SPX, until they break out in one direction or the other, they are not giving clear signals.

Market breadth has been a bit more interesting. When the selling took place in the first half of May, the “stocks only” breadth oscillator declined into deeply oversold territory, reaching –363 last Tuesday, when other oversold extremes were registered. The “NYSE-based” breadth oscillator, however, never descended to anywhere near that level. It reached –48 at its worst. When the two oscillators differ by over 300 points like that, it’s a buy signal when they contract. And that buy signal was registered yesterday. For the record, they are still about 200 apart, but neither is overbought nor oversold.

The volatility indices ($VIX and $VXO) have been important indicators. As mentioned earlier, the market turned quickly when $VIX probed up to 19 on Tuesday. That’s the third time in the last month that $VIX reached 19, and
the market rallied immediately thereafter. The rally in April was stronger than the one in early May. It remains to be seen how far this one will carry. But now, $VIX has reversed back down quickly and is below 16 again. That’s bullish in that a downward trend in $VIX is bullish for stocks. The only caution with $VIX at this level is that it might be so low as to represent “complacency” as it did in late April when $VIX neared 14.

With regards to the other volatility measures that we track: 1) the 20-day historical volatility of $SPX is 10%; it never rose above 12%, even when $SPX sold off this month; 2) the Composite Implied Volatility (CIV) of all equity options is now in the 13th percentile; however, earlier this week it rose to 21%, setting off a sell signal on Tuesday. That has been ‘canceled’ with the move back down to the 13th percentile. The May $VIX derivatives expired this week, so June is now the front month. June $VIX futures settled with a large premium of 2.13 today. The term structure is sloping rather steeply upward – at least through October, where the premium is 7.13. While it is true that an upwardsloping term structure is reflective of the bullish case, there comes a time when it is “too steep.” That is, it’s overbought. This happened in late April when the near-term premium reached 3.20 and
the October premium reached 8 points. Those premium levels marked the top of the market. So there’s a little room to expand, but the term structure is getting overbought.

In summary, the bears fumbled away yet another chance to break the market this week. Modest oversold conditions produced a strong rally, and now the indicators are mixed – which brings us to a point where a breakout could occur in either direction. A breakout through either trendline – or above 1360/below 1320 if you prefer support and resistance levels – should be “played” as it will likely lead to a more sustained move.

Expiration: expiration is pretty much a “non-event” as far as affecting the stock market is concerned. There is roughly an equal balance between expiring in-the-money call open interest and in-the-money put open interest. Thus, we don’t expect large buy or sell programs, due to option expiration today.

Larry McMillan