Stock Market

THE OPTION STRATEGIST Weekly Updater 12/24/04

The market responded nicely in early December, after the initial overbought condition was relieved. After running up strongly in the next week, there once again was a modest overbought condition. That, too, was alleviated by a 3-day hiatus in buying, and now the market is moving higher again. This is 'classic' action in a strong, young bull phase: overbought conditions are constantly generated, and then the market goes sideways or perhaps slightly down to relieve that overbought condition, and then the market rallies again. This type of action is really caused by shorts and under-invested institutional investors looking to buy on nearly any pullback. Whatever the reason, it's bullish and we continue to expect the market to rally in line with the targets outlined previously (673 and 690 are the targets for $OEX, for example). Moreover, the 'Santa Claus rally,' as defined by Yale Hirsch is upon us. It encompasses the last five trading days of one year and the first two of the next. This year, that's the entire week between Christmas and New Years, plus the first two trading days of 2005. Note that there is no market holiday surrounding New Years (that's always been the case with the NYSE when January 1st falls on a Saturday). It's certainly not very joyful of them to forsake a holiday next Friday, but I guess they need to book the extra commissions and fees that might be generated on a day when most of us would rather be off.

Equity-only put-call ratios were our first bullish indicators, with buy signals last August and October. However, they are getting 'tired' now, as the weighted ratio has given a sell signal (Figure 3) and remains on that sell signal despite the broad market's rise to new highs. The standard ratio (Figure 2) was waffling this past week and looked like it might generate a sell signal also. However, it did not, as it fell to new lows (which is bullish) when market moved to new highs.

Breadth has been strong. Even when sell signals were theoretically generated, they have quickly been erased by subsequent expansions of breadth. This is positive action, too.

Volatility ($VIX) continues to collapse, setting one new 9-year low after another (figure 4). $OEX implied volatility ($VXO) was briefly higher, but that apparently was an aberration, as it quickly collapsed back down to levels commensurate with $VIX. $VIX hasn't closed below 11 yet, but it certainly acts as if it might soon. In December, 1995, $VIX traded briefly down to 10.5. If that low is exceeded, then the previously lows were in early 1994. A recent poll in Barron's (unscientifically conducted, I'm sure) indicated that most traders expect volatility to remain low. Thinking as contrarians, we have to expect a rise in volatility soon -- but that doesn't necessarily mean the market has to fall (we've written several articles in the past, showing how volatility has increased when the market rallied -- 1995 and 1996 being classic cases in point).

To summarize, we expect to remain positive on this market unless it breaks support or trend lines. Thus price action is our major criterion -- not the technical indicators. Right now support on $SPX is 1185-1190 (Figure 1). For example, earlier this week, when it looked like there might be sell signals in both oscillators and in both equity-
only put-call rat ios, we still were not inclined to turn bearish because $SPX was holding well above support.

Rather than specifying support levels for each index, we are merely going to use the $SPX support as a guide for all indices, since it has been the strongest index in this move. So, if it breaks down, that would be negative for all the others.