Bear markets can unleash some of their scariest action while the stock market is oversold — like it is now

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The S&P 500 index has fallen nearly 500 points this month – much of it in the last week. It had tried to rally, but bumped into the 200-day moving average, which proved to be stiff resistance. Selling has accelerated from there, and now the lows of February and March (4100-4200) are being tested again.

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That entire scenario keeps the S&P SPX,
+0.21%
chart negative, in that it is still in a downtrend (blue trend lines on the accompanying chart).

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However, some major oversold conditions have arisen now that the selling has been so fierce this week. Remember, though, that “oversold does not mean buy.” Bear markets can unleash some of their scariest action while the market is oversold. It is necessary to wait for confirmed buy signals from the indicators before entering on the long side.

One oversold condition is the fact that SPX closed below the -4σ “modified Bollinger Band” (mBB), which is a setup for a new McMillan Volatility Band (MVB) buy signal. That buy signal will occur when SPX closes back above the -3σ Band and then confirms with a higher close after that. This signal sometimes takes a while to complete, but it will eventually occur now that SPX has indeed closed below the lower Band.

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Lawrence McMillan

Equity-only put-call ratios remain on sell signals. They presciently turned higher in mid-April, derived sell signals. From there, they have risen sharply, and as long as they continue to rise, they will remain on sell signals.

Clearly, they are in oversold territory (near the highs on their charts) once again, but a buy signal will only occur if they roll over and begin to decline, as they last did in mid-March.

Lawrence McMillan

Lawrence McMillan

Breadth has been terrible, as one might imagine, with such heavy selling taking place. Both breadth oscillators remain on sell signals, and they are in deeply oversold territory. There were two 90% down days this week (declines at least nine times the number of advances). The oscillators are so oversold, in fact, that it is going to take at least two – maybe three – days of positive breadth to generate buy signals.

Another oversold condition exists in what we call the “oscillator differential” – the difference between the two oscillators (“stocks only” and NYSE).

New 52-week lows continues to dominate the number of new 52-week highs, across all three data sets: NYSE, NASDAQ, and “stocks only.” In the last four days, on the NYSE, there have been fewer than 20 new highs each day, while the number of new lows has been 400 or more. This indicator thus remains on a sell signal, and it too is in an oversold state.

Let’s turn our attention to the volatility-based indicators now. VIX VIX,
-5.03%
has exploded this week, and that has stopped out the most recent “spike peak” buy signal for a loss. However, a new such signal is now setting up, since VIX is in “spiking mode” once again. This new buy signal will occur when VIX closes at least 3.00 points below the highest price that it has reached on this most recent explosion. So far, that price is 33.81 on April 26. Thus, a close below 30.81 will generate this buy signal. It is likely that this will be the first confirmed buy signal to occur.

Lawrence McMillan

The trend of VIX is still bearish though. That is, both the VIX and its 20-day moving average are above the VIX 200-day moving average (see the purple square on the lower, right-hand side of the accompanying chart). This is similar action to what occurred back in January (also denoted with a purple square).

Both of those entities would have to close below the 200-day MA in order to generate a buy signal here, and that is not going to occur anytime soon. However, if VIX alone closes below the 200-day, that would likely alleviate some of the bearish pressure.

The construct of volatility derivatives is in a fragile state but has not rolled over to a completely bearish mode. The term structure of the VIX futures is flat to slightly down in the front end of the curve. Moreover, the front-month May futures and the second-month June futures are trading at about the same price.

If the relationship deteriorates, and May begins trading significantly higher than June, a sell signal will occur. So far, that has been avoided (barely).

In summary, the major trend of this market is still bearish, and if support at 4100 gives way, the next major leg of the bear market will likely unfold. Countering that is the fact that most of the indicators are severely oversold and are likely to generate some confirmed buy signals in the near future. So, we are holding a “core” bearish position, but will trade other confirmed signals around it.

New recommendation: Potential VIX ‘spike peak’ buy signal

VIX re-entered “spiking mode” on April 22. Since then, it has plowed its way to a high of 33.81 (so far), on April 26. On April 27, VIX closed at 31.60, which is not more than 3.00 points below that intraday high.

A new “spike peak” buy signal will occur when VIX closes at least 3.00 points below the highest price that it has traded at since April 26 (which, as noted, is currently 33.81 but could be a higher number if VIX is up strongly in the short term).

As we have frequently stated, we are not going to ignore any signals, so we are going to take a position in line with this one:

IF VIX closes at least 3.00 points below the highest price that it has reached since April 26, THEN

Buy 1 SPY May (27)th) at-the-money call

And sell 1 SPY May (27)th) call with a striking price 15 points higher.

If established, we will hold this position for 22 trading days, unless it is stopped out by VIX closing above that most recent high.

New recommendation: Potential MVB buy signal

As noted above, SPX has closed below the -4σ mBB, and a MVB buy signal will eventually occur. First, SPX needs to close above the -3σ Band, and then it needs to confirm that with an eventual close higher. The criteria are laid out in the following table:

IF SPX closes above this price…

on this date…

4243

Thursday, April 28

4235

Friday, April 29

4227

Monday, May 2

4220

Tuesday, May 3

4215

Wednesday, May 4

THEN note the high price of SPX on the day that happened.

IF SPX later closes above that high price,

THEN

Buy 1 SPY June (17)th) at-the-money call

And sell 1 SPY June (17th) call with a striking price 17 points higher.

As an example, suppose the SPX closes at 4245 today, thereby fulfilling the first condition. And furthermore suppose that the high of the day for SPX was 4255. Then the MVB buy signal would occur if SPX later closes above 4255.

New Recommendation: Mattell

A new takeover rumor has arisen in Mattell MAT,
+10.76%
after it was published in the financial media that the company is seeking to evaluate strategic alternatives. Mattell released earnings after the close on Wednesday but refused to comment on the potential takeover situation. Option volume has jumped higher, and stock volume patterns are improving. There is support at 23.50.

Buy 4 MAT May (20)th) 25 calls in line with the market.

MAT: 24.49 May (20th) 25 call: 1.10 bid, offered at 1.35

Lawrence McMillan

Follow-up action

All stops are mental closing stops unless otherwise noted.

We are going to implement a “standard” rolling procedure for our SPY spreads: in any vertical bull or bear spread, if the underlying hits the short strike, then roll the entire spread. That would be roll up in the case of a call bull spread, or roll down in the case of a bear put spread. Stay in the same expiration, and keep the distance between the strikes the same unless otherwise instructed.

Long 2 ZEN May (20th) 125 calls and Short 2 May (20th) 140 calls: The stock gapped to the upside when Zendesk ZEN,
+0.01%
began to evaluate strategic alternatives. Hold without a stop while the activist activity is in progress.

Long 0 ORCL May (20th) 82.5 calls: We bought calls near the close of trading on March 15, when Oracle ORCL,
+0.34%
closed above 78, and later rolled up. But the position was stopped out on April 22, when Oracle closed below 78.50.

Long 2 FRT May (20th) 125 calls: Hold as long as the put-call ratio remains on a buy signal, as it is continuing to do.

Long 0 SPY May (6th) 449 calls and short 0 SPY May (6th) 464 calls: This spread as bought in line with the VIX “spike peak” buy signal of April 7. It was stopped out when VIX closed above 24.78 on April 22. A new “spike peak” buy signal is setting up now (see recommendation in the newsletter above).

Long 3 SAVE May (20th) 25 calls: Hold without a stop for now, as competing bids are still in place for Spirit Airlines. SAVE,
+0.32%
,

,

Credit: www.marketwatch.com /

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