The first cracks in the bullish dam are beginning to show. As a result,
the correction that we've spoken about for some time is upon us.
Whether it proves to be a sharp, but short-lived correction (such as the
30-point $SPX correction in June) or something more permanent,
remains to be seen. But, for now, caution is warranted for bullish
investors, while aggressive investors can take bearish positions
understanding that they may have to exit quickly.
The major averages have not violated support, so that is one factor
in favor of the bulls. $SPX has near-term support at 1228-1230, and as
long as that holds, we would still rate the $SPX chart as bullish. $SPX
recently made a new 4-year high, but QQQQ appears to have failed in its
quest to exceed last fall's highs. $OEX and $DJX (the Dow) are the
under-performers, having failed to even exceed last week's highs. Of
course, the best performers have been the small caps ($VLE, $RUT, and
$SML). The current index chart is very similar to what we saw back in
June: $SPX has been "walking the tightrope." That is, it has been
crawling along the Upper Bollinger Band (see Figure 1). When it
releases downward from there, the correction is at hand. Back in June,
$SPX dropped 30 points in less than three days. Thursday, it appears
that the same sort of thing has begun again, in August.
Equity-only put-call ratios are still on buy signals. Recently, both
ratios (Figures 2 and 3) had dropped to new 2005 lows, and were heading
for the lower regions of their charts. While we don't use absolute levels
on the chart as indications of buy or sell, such low levels can define an
overbought condition. The standard ratio has stopped declining now, as
the market has weakened, but the weighted ratio continues to plunge.
Neither of these ratios has rolled over to a sell signal, so they remain
bullish.
Market breadth has been running very strong for some time, which
is good. However, as usual, that produces an overbought condition.
Now, with Thursday's action developing very negative breadth, this
is a sell signal.
Volatility ($VIX) was the first indicator to warn that a correction
was upon us. It started to rise a week ago, and has added nearly 3 points
from its recent lows. The fact that it was rising while the overall, broad
market was also rising was a warning sign. Figure 4 shows how a similar
formation near the end of 2004 -- rising volatility in a rising market
heralded the 50-point $SPX correction that ensued at that time. Hence,
we take this increase in $VIX seriously.
In summary, bulls should lighten positions and tighten stops. Bears
and other aggressive investors can buy puts on major indices.
