McMillan Market Commentary, Friday morning 7/15

The market action this week has been quite bearish and, frankly, quite out of character in terms of
the indicators. It seems to be at odds with some of the indicators, but it may also be a rather severe
reaction to the overbought conditions that had built up.

The S&P 500 Index ($SPX) had strong upside momentum a week ago, but ran into resistance very near the April highs. It has failed badly since then, with several support levels failing to hold. The 1315 support level gave way today, and now $SPX has traded down to near the stillrising 20-day moving average. It has closed below 1310,

which was an important level to overcome on the way up, and now the last bastion of support seems to be 1300.

What has been really surprising is the swift change from a generally bullish environment – for example,

where rallies near the end of the day were common – to one in which rallies can’t gain a foothold for

more than a few hours. The oversold conditions that we saw at the June lows were quite extreme –

especially the magnitude of put-call ratios, and the depth of the breadth oscillators. Those types of readings normally indicate a much longer move upward than we got, and considering the early strength of the move, it is even more surprising. Clearly, there is another mentality at work, at least in the short term. Rumors are that some major hedge funds have had such miserable years to date, and then got whipsawed both at the June bottom
and then the July top (so far), that they are in danger of folding. This week’s selling seems to reflect
a panic of that sort. Whether it has to do with the fact that the U.S. may have to suffer a downgrade
in its debt rating (as threatened by Moody’s this week), I don’t know, but this is hardly “new” news.

Equity-only put-call ratios are bullish and have remained bullish even during this week’s
decline (mostly because they are 21-day moving averages, and 21 days ago there was still heavy
selling in June and hence high put-call ratios, similar to the ones we saw this week). Not only are
the charts bullish, but the total put-call ratio completed its long-awaited buy signal officially
today. That is, the peak in the 21-day moving average of the total put-call ratio was 10 days ago.
Hence, the buy signal officially kicks in at $SPX 1308.87. As you know, 8 of the previous 12
signals have produced an $SPX rally of 100 points. The four losing signals were quickly followed
by another total put-call ratio setup, eventually resulting in the requisite 100-point rally. For
example, the buy signal in June 2010 failed, but was quickly followed by a buy signal in July that
produced the 100-point rally. These rallies generally occur in three or four months, although one
took only a week (October, 2008) and another took eight months (in the slow-moving market of

Breadth was extremely strong on the way up, and has been extremely negative on the way
down. It’s as if everyone is acting in unison. There has only been one “90% day,”
though – a down day earlier this week. Officially, the breadth oscillator re-entered sell
signals as of today’s close.

The volatility indices ($VIX and $VXO) have been the most bearish this week.
$VIX actually closed below 16 (barely) last week, and once again that was a harbinger of a
market selloff. Now $VIX is shooting upward, reaching above 21 today. Hence it has already
sliced through its moving average and has established an uptrend, which is bearish for

If $VIX were to close below 18, that would move this indicatornnnnnnnnn back to
bullish status. However, there are scare stories circulating that $VIX could explode to the
upside if a debt downgrade really does take hold. Probably unlikely, but be sure to own some

out-of-the-money $VIX calls just in case.

The $VIX futures have traded at a small discount to $VIX at times this week. The July $VIX
futures expire next Wednesday, so most of the action is concentrated on the August futures now.
Both July and August closed at a 20 cent discount today. However, all of the other futures contracts
are still at relatively large premiums (November is 3.10, for example). Moreover the term structure
continues to slope upward, although it did flatten by a small amount today. Even so, with most of
the futures trading at a premium and the term structure still sloping upward, that is the sign of a
bullish environment – not a bearish one (if more futures begin to trade at discounts and the term
structure begins to flatten, that would be a bearish indication).

One other thing: the Arms Index (also known as TRIN) registered a monstrous reading of 5.37 on Monday –

one of the highest readings in history. Typically, that is an indication of a selling climax, and at least a

short-term rally should result. There has been no such rally (other than some intraday affairs),

so this is an “oversold” condition that should kick in here soon.

Finally, this is expiration week. We normally don’t publish on the day before expiration –
only when the second Thursday (publication day) is the day before the third Friday (expiration).
Due to fact that the market is relatively near the middle of its range over the last month, there is little
chance for option expiration to have significant influence over the market today.

In summary, we remain bullish as long as $SPX continues to close above 1300 – based on the

put-call ratio buy signals, at least. A close below there would make us neutral, relegating the
index to trading range status.

Larry McMillan