The market has sold off rather sharply this week, and that has had the
effect of creating some extremely overbought readings. Such readings
make likely the prospect of a sharp, but short-lived rally. True buy
signals, however, have not set up yet.
Let's discuss price action first. Last week, the major indices fell
below their trend line, and that was really the first breaking of the
bullish trend that had started last October. After declining more
modestly for a few days, another large breakdown occurred this week
when the February lows gave way. These movements were in line
with our expectation of a test of the January lows. The January lows
are roughly 1165 for $SPX, 555 for $OEX, and 10,350 for the Dow.
None have really reached those levels yet, although $SPX came within
a couple of points recently. If you look at the chart of $SPX (Figure
1) you will see that there is actually another trend line in play -- the
one that connects the August and October, 2004, bottoms. Ironically,
it is currently near 1165 (basis $SPX) as well. That makes the 1165
level quite important, for if it is broken to the downside, then another
waterfall decline might result. There is really nothing about the charts
of the major indices that can be considered bullish, so we will have to
rely on other indicators for buy signals.
One of those other indicators, is the equity-only put-call ratio. As
you can see from the figures above, these are still on sell signals.
These will remain bearish until they roll over and begin to decline.
The weighted ratio (Figure 3) is not near such a roll-over, but the
standard ratio (Figure 2) could roll over quite quickly, according
to our computer projections.
Breadth has become extremely oversold, which usually indicates
that a very short-term rally is possible.
Finally, there is volatility ($VIX). We had been expecting $VIX
to rise sharply when the market finally broke down below the February
lows. It did that, with $VIX jumping to a new 2005 high (briefly) at
that time. However, $VIX quickly reversed itself and now looks like
it has left a spike peak on its chart. Spike peaks in $VIX are buy
signals, so this may be the first buy signal of the group. We say "may
be" because it seems somewhat incredulous that index option traders
can remain so complacent in the face of the sharpest market decline
since last summer. Regardless of our skepticism, such a sharp decline
in $VIX is a buy signal -- until and unless it exceeds that peak at a later
date.
In summary, we expect an oversold rally will occur, followed by
a test of the January lows. If they hold, then a more lasting rally is
possible, but if they don't hold, then expect even heavier selling than
we've recently seen.
