We're in for a Scare

 | Jan 09, 2012 | 6:31 AM EST
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When I look back at the closing levels of the S&P 500 for the past week, I see three out of four days finished at 1277 and one at 1281. How is that for chopping about?

This has become a common theme in the market: rally and no follow-through, decline and no-follow through. Many have inquired if this means the market lacks institutional support. In this day and age, how can we tell when most of the trading is done by machines?

What we do know is that volume was relatively light yet again. We also know the number of stocks at new highs is now half what it was last Tuesday -- which were less than what it was the week before. We know the market is overbought, although the good news there is that this condition has been present for a week, and the chopping has been slowly relieving it.

We know the resistance overhead is still present, as well. Last week I discussed the resistance in the Dow and S&P, and pointed out that it appeared the Russell move looked as though it wasn't really quite sure it wanted to break out.

The only change in any indicator I saw late last week was the rise in the put-call ratio of the CBOE Volatility Index (VIX). When I saw this rise I thought, gosh, I cannot recall the last time market analysts fussed over the "low VIX" the way they did last time the index was down here near 20. However, our concern is more for the put-call ratio of the VIX. It is now the highest it has been since late October. Keep in mind this is a very short-term tool.

On the chart below, I have boxed off the last few times when there was been a similar rise in this indicator. It is not exact, as we won't necessarily see a big down day immediately following a sharp rise. Often, it arrives one to three days later.

Put-Call Ratio of the VIX

In late September, such a VIX climb resulted in a very sharp market pullback, and the same goes for November and December. In October, which I have indicated with an arrow, the market rallied for another two trading days. The following pullback was quick, being one of those down-2% days that had no follow-though. There was a similar such pattern about a week after that (not boxed on the chart)

So, let's consider what's currently happening. The market is still overbought, the 10-day moving average of the equity put-call ratio is trying to turn up and new highs are lagging. The resistance overhead is still present, and now we're seeing the high put-call ratio of the VIX as well. In light of all this, I would say the market is are due for a little scare this week.

I have noticed a pattern we see often at earnings in the market. If, during the first week or so of earnings, the market corrects, folks tend to lower their expectations and expect the worst in that final week of the season. Yet, more often than not, that lowered expectation actually ignites a better than expected rally in the final week of earnings.

I bring this up because, if you will recall the discussion in Friday's column on the intermediate-term oversold and overbought position, it shows that stocks are moderately intermediate-term overbought this week, but then the market should back off and rally again late in the month. That, in turn, should generate a maximum-overbought reading.  The indicators seem to be lining up with that earnings pattern discussed above: some downside that sucks 'em into a negative state of mind, and then surprises on the upside.


Overbought/Oversold Oscillator -- NYSE

Overbought/Oversold Oscillator -- Nasdaq

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