This week's drop in the market -- particularly the large decline on Tuesday -- has eliminated the overbought condition that existed. We had been looking for the market to move sideways to slightly down in order for that overbought condition to be alleviated, and that is exactly what's happened. It should be noted that the major averages have only declined by a small amount, and no major support areas have been violated (see chart, page 11). However, the crucial point in time has arrived. If this market is to respond the way that many past markets have responded in the wake of a massive overbought condition, then it should start to rise soon. We still look for an intermediate-term advance which could carry the market 20% higher from here. However, there is crucial support under this market which, if violated, would negate our hypotheses. For $OEX, that support is 555-557, for $SPX it's 1170-1172, for the Dow, it's 10,400, and for QQQ is roughly 38 to 38-1/2. There are other support levels below those (547 for $OEX and 1160 for $SPX), where the market broke out from in November. However, if we correct all the way back to those levels, we think the momentum of the November rally would have been lost and, while those lower support levels might generate a rally, it would not be of the magnitude that we currently envision.
Market breadth plays an important part here, of course. The big decline this week removed the overbought breadth condition. Breadth has not gotten oversold, but that's okay, for in the past when the intermediate term rallies did take hold, they did so without breadth getting oversold enough to generate a "true" buy signal. In other words, the market is powerful enough that it contains the selling and rises before it's obvious that a buy signal has occurred. On the other hand, if this decline doesn't halt and the market drops further -- perhaps to those afore-mentioned lower support areas -- then we'd probably see breadth get oversold and register true buy signals. But again, that's not our optimum scenario.
The equity-only put-call ratios remain in downtrends, which is bullish (charts above). True, the weighted ratio has reached the bottom of the chart, but in strong bullish markets, it has declined farther -- to the 20 area or so before generating sell signals. So these remain some of our most bullish indicators, as they have been all along -- ever since the major buy signals back in August.
Finally, volatility ($VIX) has remained subdued, which we also view as bullish. Even during Tuesday's large decline, $VIX only edged up fractionally. If the "smart money" becomes worried, they usually pay up for index put options and $VIX rises quickly. We are staying with our analysis that $VIX won't be worrisome unless it rises above 16.
So, in summary, the market is at an inflection point. If support holds -- as we suspect it will -- then a major, intermediate term rally should unfold (possibly aided by the positive seasonality that exists at the end of December). However, if that support gives way, then we're back in more of a trading range, short-term environment and we would adjust our thinking accordingly.
Lawrence G. McMillan
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Lawrence G. McMillan is the author of Options As a Strategic Investment, the best-selling work on stock and index options strategies, which has sold over 200,000 copies. The fourth edition of this work was just released in March 2002. In addition, his other book, McMillan On Options, was published in October, 1996. He currently authors a unique daily fax service -- Daily Volume Alerts -- which selects short-term stock trades by looking for unusual increases in equity option volume. He also edits and publishes "The Option Strategist", a derivative products newsletter covering equity, index, and futures options, as well as "The Daily Strategist", covering much the same strategies but on a daily basis. In these capacities, he is the President of McMillan Analysis Corporation, which he founded in 1991. He has spoken on option strategies at many seminars and colloquiums in the United States, Canada, and Europe. In addition, he trades his own account actively and manages accounts for others in the option markets.
Lawrence G. McMillan has spoken on option strategies at many seminars and colloquiums in the United States, Canada, and Europe. He is a guest speaker on Bloomberg TV, CNBC and Bloomberg Radio. He also writes regularly for "The Exchange", a publication of Data Broacasting Corp., and authors a weekly columns for WorldlyInvestor.com, and MarketMavens.com. In addition, he trades his own account actively and manages accounts for others in the option markets.
From 1982 to 1989, he was in charge of the Equity Arbitrage Department at Thomson McKinnon Securities, Inc. and then was in charge of the Proprietary Option Trading Department at Prudential-Bache Securities in 1989-90. Before holding those positions, he was the retail option strategist at Thomson McKinnon from 1976 to 1980, and then traded the firm's proprietary account beginning in 1980.
Mr. McMillan holds a B.S. degree in mathematics from Purdue University (1968) and an M.S. in applied mathematics and computer science from the University of Colorado (1972).
McMillan Analysis Corporation, headed by best-selling author Lawrence G. McMillan, has been providing options oriented advice and learning tools since 1990. Mr. McMillan, with over 26 years of option trading experience, is the editor behind all advisories and services published by McMillan Analysis. We offer a wide array of learning and analysis tools for serious traders and option students. We believe an informed and educated trader makes a better client. We strive to make an important difference for our viewers. We think you'll agree, as do many of our clients, that we offer superior options products and services.
