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The hated bull market

Posted in on July 31, 2012 - 4:14pm

By Lawrence G. McMillan

MORRISTOWN, N.J. (MarketWatch) — Since the broad stock market, as measured by the Standard & Poor’s 500 Index, bottomed in early June, the ensuing rise has been met with doubt, skepticism, and even outright derision (dare we say “hate?”) in some cases.
The bears are supposed to be the smart money, while bulls are just innocents being led to slaughter. After all, aren’t the fundamentals all bearish: European problems in Greece, Spain, and even Italy; sluggish economic numbers in the U.S.; poor corporate profits this quarter; and so forth? Yet the S&P 500 SPX -0.43% just made another new relative high for this move, and the majority of the technical indicators that we follow are bullish. Perhaps all the traders who wanted to sell on the old news — most of which are not new stories — have sold long ago, leaving the playing field to a new, less vocal, set of buyers.

The chart of SPX shows the classic bullish pattern of higher highs and higher lows. The lines connecting these make an upward-sloping channel on its chart. As long as that channel is intact, the bullish scenario is in place. At the current time, SPX is nearing the upper regions of the channel, and so there might be another short-lived correction down toward the lower end. But that should be viewed as a buying opportunity, much as the last couple have been.
Yes, these corrections can be a bit scary: The one in early July saw the broad market decline for six consecutive days, and the more recent one saw SPX drop sharply for three straight days. But both were just buying opportunities, and the next one will be, too, unless SPX violates the support at 1,330 on a closing basis.
Equity-only put-call ratio signals remain on buy signals. These important intermediate-term indicators have not wavered since early June, when they gave the initial buy signals. To be certain, there is not really the amount of put buying now that there was then, but these buy signals remain intact.
The Total put-call ratio — which has a target of 1,440 (SPX) on its last buy signal — remains bullish as well. In fact, the Total ratio is considered “too pessimistic” when its 21-day moving average is above 90 (i.e., 90% of all options traded at puts), and it is still above that 90 level, even though the rally has been in progress for nearly two months. This one statistic shows just how little faith most traders — even hedge funds and institutions — have in this rally. It is for that reason that short-covered spikes, such as we saw last Friday, can drive this market higher when upside momentum gathers strength.
Market breadth indicators are once again on buy signals. The sharp three-day decline has actually “refreshed” these signals, as breadth indicators dipped into oversold territory before recovering and therefore issuing new buy signals. These breadth indicators are relatively short-term ones, and so with SPX now back near the top of its trading range, we are seeing some overbought conditions spring up here. Overbought conditions of this nature are not trend-changing, but merely signify that a short-lived correction is possible.

Volatility indexes VIX & VXO fell sharply after VIX reached 21 last week. It plunged all the way below 17 this week. In my view, as long as VIX is below 21, it remains conducive to higher stock prices. VIX becomes somewhat overbought when it falls below 17, and it hasn’t been able to stay there for long. But VIX won’t give a bearish signal until it closes above 21. In the last couple of days, VIX has increased while the market has remained flat. This reflects the heavy demand that exists for protection amongst stock traders (in this case, that means they are buying SPX puts).
The construct of the VIX futures remains positive as well. There are two components to this construct. The first is the level of premium on the VIX futures. This premium remains fairly large, although not as large as it was at its maximum. The front month (August) premium is only about 1.00 point, but premium increases out along the futures spectrum, to the point where March 2013 futures premium is 8.41 — really quite huge.
The second component is the term structure of the futures — the relationship of the futures contracts to each other. In this case, that term structure slopes steeply upward, as each longer-term contract trades at a higher price than its predecessor. The general construct of premium on the futures and an upward-sloping term structure is a bullish pattern for stocks. A bearish pattern would occur if the term structure flattened and began to slope downward. That doesn’t seem likely to occur for some time.
By the way, this construct of the VIX futures has persisted for so long because, once again, there is a voracious appetite for protective devices — whether they be SPX puts (which drives up the price of VIX), VIX options and futures, or volatility ETNs and ETFs (which drive up the price of VIX futures). As long as so many investors are convinced that they need protection, it will likely prove to be of little use to them.
In summary, the bullish indicators are showing the way for higher SPX prices, but perhaps not before another short-lived, but potentially sharp correction. The intermediate-term picture is for SPX to advance to 1,440 and probably higher. It would not be entirely out of the question for SPX to be able to challenge its all-time highs at 1,550, although that is not a certainty by any means.
More accurately, this bullish move can be expected to prevail until the majority of traders get behind it. Once they turn bullish, the bloom will be off the rose. But as long as this bull market remains hated by the media and many, many traders, it can continue rise.
Source - MarketWatch