McMillan Market Commentary for Friday Morning 7/1

A huge stock market rally developed this week, due to a number of factors. In the aftermath, one is left
wondering if an “engineered” move counts just as much as a natural move. That’s what we’ll have to

The S&P500 Index ($SPX) entered the week in a downtrend. Depending on how you look at things, it
might still be in a downtrend. But it did overcome resistance at 1300 (last week’s high) and 1310,

so that is a positive development. So now we have a short-term bullish uptrend running into
a longer-term bearish downtrend. A close above today’s highs at 1320 would be further confirmation
that the chart has turned bullish. However, a failure here could indicate that this week’s move was just an
over-exuberant oversold rally that carried a bit farther than usual. The market has rallied so quickly
that some overbought conditions are already beginning to appear.

It doesn’t particularly matter why the market rallied – at least from a technician’s viewpoint.
Although, one wonders if the confluence of month-end window dressing, a modestly severe oversold
condition, the Greek austerity vote, and the end of QE2 came together to push $SPX higher, farther,
and faster than it normally would have moved. There certainly was a “reallocation” this week, as
large traders sold bonds and bought stocks. That is an “honest” market move, as was the response
to the oversold condition, but the others are not sustainable buying.

Put-call ratios have reached extreme levels, but have stubbornly been refusing to give
confirmed buy signals. The standard equity-only put-call ratio is closest to a complete
buy signal, but it has wavering back and forth rather than creating a clear downtrend. The weighted
ratio only today curled downward; previously it had just been rising day after day. The computer
program that we use to analyze these charts calls this a buy signal as well.

Finally, the total ratio (see last two issues of The Option Strategist newsletter for background
on this ratio) has had the most problem generating a buy signal. Only yesterday (Wednesday, June
29th), its 21-day moving average made a new high (just like the weighted ratio did).
Today, it backed off quite a bit, but the definition of the buy signal is that it comes after the ratio has
peaked for 10 days. It had gone 8 days from the tentative previous peak before making new highs
on Wednesday and creating the “start over” situation. The good news, though, is that a lot of large
numbers are ready to come off the 21-day moving average of the total put-call ratio. That enhances
the probability that yesterday’s high will indeed eventually be the confirmed buy signal.

Volatility indices ($VIX and $VXO) collapsed this week. That certainly changed the chart of $VIX from bearish to bullish. Like $SPX, it exceeded last week’s extremes – by falling below 17.70 in this case. $VIX actually
traded below 16 today, although it didn’t close there. The problem is that in the last few
months, whenever $VIX closes below 16, it is signaling an extreme overbought condition, and
the market has backed off. The last time this happened was slightly over a month ago – in late May.

Breadth indicators turned to buy signals slightly over a week ago. At first, they were
having trouble gaining traction. This week, they finally launched heavily upward as breadth
has been extremely strong this week. In “stocks only” terms, there have been 7,300 more advances than declines in the past four days. NYSE-based data produced about 5,600 more advances than declines. Needless to say, the breadth oscillators are overbought. However, in a new bullish stage, there should be extremely overbought readings. So, while this might indicate a slowdown in the rate of advance, it could be a bullish signal as well.

For most of this week, $VIX futures did not fall as fast as $VIX. Thus, the $VIX futures all
have a large premium on them once again. Furthermore, the term structure’s upward slope has
steepened all week as well. Thus, this construct is confirmation of the bullish case, but it is also
beginning to reach overbought status.

One of the other volatility measures that we follow is quickly moving towards overbought
status as well. The Composite Implied Volatility (CIV) of all equity options is plunging, and is back
down to the 13th percentile. Once it goes below the 10th percentile, a sell signal setup is in place.
The slower-moving historical volatility of $SPX is near 15% and is not overbought at this time.

In summary, $SPX overcame resistance and if it can break the downtrend line, that would be

the final confirmation that its chart has turned bullish. It might pull back towards the 20-
day moving average at 1290 before doing so, but any pullbacks should be brief if “the” bottom is
in. Put-call ratios are turning bullish, $VIX has already turned bullish, and breadth turned bullish
a week ago. Overbought conditions might be a concern (especially the ones from $VIX), but the
weight of the technical evidence is bullish enough that long positions are warranted.

Larry McMillan