The market moves swiftly but goes nowhere

By Lawrence G. McMillan

MORRISTOWN, N.J. (MarketWatch) — Despite plenty of volatility, the stock market – as measured by the Standard & Poors 500 Index — has been unable to break out of its rather wide trading range. That might remain the case for the remainder of this year, but it is likely that early 2012 will see a significant move.

Early this month, there were several probes up towards resistance. It topped out near 1,270, on several consecutive days. This resistance area was also very near the 200-day moving average of the S&P 500, which has been receiving a lot of attention — so much so, in fact, that it has become a sort of self-fulfilling indicator. Regardless, there is most certainly resistance in that area, and until SPX can clearly break out over it, the bullish case has little credibility — at least at current market levels.

As for support, there is a major trend line connecting the October and November bottoms. That is sort of the demarcation line of this present rally. That line is currently at about 1,180. However, there is also support above that — at the 1,225-1,230 level, which is the area of recent lows, established in the last week. If the 1,225 area gives way, then the focus will be on that trend line.

You can see from the figure below that there are converging downtrend and uptrend lines. When these persist for long periods of time, as they have, then a breakout should be significant. The break of the blue trendline in September propelled the market to its October lows. We would expect the next breakout in either direction to exceed the highs or lows on the chart below (i.e., above 1,350 on an upside breakout, or below 1,080 on a downside breakout).

Equity-only put-call ratios have been modestly bullish of late. This contrary indicator has a good track record. In recent months and weeks, there has been a lot of put buying — and there continues to be. Hence, these indicators are rather elevated, and they are now declining somewhat. This is a bullish sign for stocks as long as it persists. It is the trend of these ratios that is important, for the generally elevated level of put buying is due to traders hedging long stock portfolios. Those traders are not really bearish, per se, since they still own stocks, but they aren’t completely bullish either, since they are hedging by buying puts. As a result, they are more or less “noise” within the general level of option volume that is trading daily. But the trend of option buying shows the true direction of the speculator. Hence when the ratios are dropping from high levels to low(er) levels, that is a bullish sign for stocks.

Market breadth has been as wild as ever. It swings with abandon from day to day, as traders rush in to buy and sell — spurred by the same news items. As a result, most days see far more than 2,000 issues moving in the same direction (out of about 3,000 total issues). What’s happening here is that hedge funds and other large traders are not so much trading in individual stocks as they are trading off the headlines. Hence they wind up doing the same thing (buying or selling) at the same time — not out of collusion, but out of almost identical trading philosophies.

While this persists, overbought and oversold positions appear with great frequency. We watch for “90% days” — days in which advances lead declines by a 9-to-1 ratio or more, or advancing volume leads declining volume by a 9-to-1 ratio or more, or vice versa. A “90% day” typically means that the market is overbought/oversold and needs to move back in the other direction. This type of action has been repeating like clockwork. Last Thursday, $SPX was down 27 and a “90% down day” occurred. The next day $SPX responded by rallying 21 points. However, that rally created a “90% up day” and so the reaction to that was a 19 point $SPX decline on Monday. That swift decline created a “90% down volume day,” and so the market rallied 13 points (at one point today). Whew! The frequency of these “90% days” is high; in a broad, longer-term sense, that means that the market is bottoming, but severe declines could still occur in the short-term.

The volatility indexes VIX +3.19%  XX:VXO -2.96%   are perhaps the most interesting indicators. Yesterday, VIX was not advancing even though the market was falling. Then, when a modest rally arose in late trading, VIX literally plunged — winding up negative for the day. That downward momentum continued today, during the early rally, when VIX dropped to 23.27 — its lowest reading since late July. Even with SPX having fallen back after that, VIX is barely above 25. It isn’t totally unusual to see VIX drop late in the year, for there is a seasonal tendency for VIX to decline between October and year-end.

However, the VIX futures are behaving in an unusual manner. They are trading at large premiums to VIX. The December VIX futures — which we know appear as “under-priced” because of the three holidays between December and January option expiration — are trading at a premium of 2.62 to VIX. That’s pretty big for a contract that’s going to expire in 7 days (on Dec. 21). Furthermore, the January VIX futures are currently at a premium of 5.62 to VIX!!! That rates 3 exclamation points because it’s huge. By inference, you can see that the spread between January and December is a whopping 3 points, as well.

When VIX futures were “smart money” (it’s not clear if they still are), this was an extremely bearish forecast. The futures are “saying” that VIX will eventually rise, and of course the market drops when that happens. But even if the futures aren’t smart money any more, they still have to converge to parity with VIX at expiration. Hence, the hedged strategy of buying puts on VIX futures and buying puts on SPX is attractive at this time.

Finally, there is a seasonal bullishness to the market between Thanksgiving and Christmas. That seems to be partly at work right now as well. This is not the “Santa Claus rally” — which refers to the last five trading days of one year and the first two of the next. We’ll have to wait to see if there is a Santa Claus rally this year. The old saying is “If Santa Claus fails to call, bears may come to Broad and Wall.” But we won’t know about that until early next year.

In summary, there are lot of cross-currents, which has resulted in the market moving swiftly but going nowhere. The large trading range, demarcated by the two converging trend lines, can’t last forever, though. It is likely that a breakout will occur early next year, and we would expect that breakout to follow through with a strong move. From the current viewpoint, it’s unclear the direction that breakout will take, but if the VIX futures continue to carry these high premium levels, that would be a bearish forecast.

Source: Marketwatch  - The market moves swiftly but goes nowhere