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July 19, 2011, 5:22 p.m. EDT
By Lawrence G. McMillan
MORRISTOWN, N.J. (MarketWatch) "” The market had a powerful showing Tuesday with the Standard & Poor's 500 Index rallying 1.6% for the day. Market indicators suggest a potential 100-point rise in the index over the next few months.
The stock market suffered some heavy selling in the first half of June, thereby creating some contrary buy signals that eventually took place in late June. Those signals have been called into question with the market decline thus far in July, but it appears that bearish concerns are overblown and are just the market's way of luring bulls out of their positions before a strong upside breakout takes place.
I usually follow four major indicators, two of which are heavily oriented toward options and two of which are not. The first is merely the chart of the Standard & Poor's 500 Index /quotes/zigman/3870025 SPX +1.37% . It is the ultimate arbiter, in that price is always correct, no matter what other indicators might say.
There is some legitimate debate as to how one might interpret the S&P 500 chart: Is it in a wide trading range between 1,260 (the March and June lows) and 1,360 (the "bin Laden" May highs), or is it bullish because there now is a higher low coming off the June lows, and the 20-day moving average is rising?
I favor the latter, but we'll know for sure in a short while. If the S&P can exceed the 1,355 highs, then we'll have a pattern of higher highs and higher lows, and that would activate targets in the 1,425 neighborhood or so. However, a close below Monday's lows at 1,295 would negate that bullish picture.
One major option-oriented indicator that is important is the weighted equity-only put-call ratio: the ratio of puts traded to calls traded, considering stock options only. These ratios rose to extreme highs of pessimism in mid-June, equaling the same levels of pessimism that existed a year or so ago "” before a large rally took place.
When "everyone" is buying puts, it's time for the contrarian to turn bullish on the market. In addition, another put-call ratio "” the total ratio, which includes all listed options that trade (except futures options) "” gave a major buy signal. This is only the 13th buy signal from this indicator in the last 11 years. In each of the previous 12 signals, the S&P 500 has subsequently risen 100 points or more. The 100-point move usually takes place within three months or so, although in the slow-moving bull market of 2006, it took eight months.
The latest total put-call ratio buy signal occurred last Thursday, with the S&P at 1,309. These put-call ratios have remained bullish even during the market selloff that has taken place so far in July.
It may seem strange to some that these put-call ratios haven't wavered at all in their bullishness, even though the market sold off pretty hard over the last 10 days. Part of the reason is that these are 21-day moving averages, and very large put buying was taking place 20 to 30 days ago, so big numbers were coming off the moving average, making it easier for it to move lower. However, I don't think one should look too deeply inside indicators, for doing so can sometimes obscure a relatively simple signal "” which in this case is "buy."
Market breadth is the third indicator we observe. In recent months, this has not been a particularly trustworthy indicator for intermediate-term trading, but it is still useful for short-term trading. It seems that so many institutions and hedge funds act in concert, so breadth is either extremely positive or extremely negative almost every day. Breadth did become extremely oversold at the June lows, and the quickly reversed to become extremely overbought at the July highs. Currently it is in more of a neutral state.
The last indicator that we follow is the CBOE's Volatility Index /quotes/zigman/2766221 VIX -9.48% , along with its futures and options. When VIX is strongly trending in one direction or the other, the stock market typically trends in the opposite direction. Moreover, if VIX makes a spike peak on its chart, that is usually a good short-term buy signal for stocks. VIX has been moving higher over the past to days, and that has accompanied the market downturn over that time "” no real surprise there. However, after reaching a peak near 22 Monday, VIX is now reversing backward. In my opinion, a VIX close below 19 would complete a spike peak reversal buy signal.
That's a buy signal for the stock market, by the way, not for VIX itself.
In addition, one can often gain some insight into the overall structure of the stock market by observing the term structure of the VIX futures "” that is, their relationship to each other. At the current time, each successive VIX futures contract is trading at a higher price than its immediate predecessor. That is, September is higher than August, October is higher than September, and so forth.
When the term structure slopes upward like this, that is a reflection of a bullish environment. Furthermore, it pays to look at the relationship of each futures contract to $VIX itself. If the futures are trading higher than VIX, that is a bullish construct as well. So, even during the rather sharp market selling in July, the VIX futures have retained a premium, and the term structure has remained positively sloped. Thus, they are presenting a bullish picture. Conversely, if the futures should start to trade at a discount to VIX, and if the term structure should flatten out, or perhaps even begin to slope negatively downward, those would be bearish signs. They have not occurred.
In summary, the bears had a chance to wound this market, backed by some overly negative reactions to European debt crises and U.S. debit ceiling limitations. However, they couldn't really turn the indicators negative, nor even get the S&P to close meaningfully below its rising 20-day moving average.
In my opinion, they lost their opportunity. Bullish cash has been building on the sidelines, and with the backing of buy signals from contrary option indicators, this should be able to propel the market higher to at least satisfy the expected 100-point rise in SPX, over the next few months.
Lawrence G. McMillan is president of McMillan Analysis Corp. He is an experienced trader and money manager and is the author of the best-selling book, " Options as a Strategic Investment " and editor of the " MarketWatch Options Trader " newsletter.
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