Market rally continues despite low volatility

The broad market, as measured by the Standard & Poor's 500 Index - as well as the Value Line Index, the NYSE Index, and the Dow Jones Transportation Average - broke out to new highs. This time, the breakout quickly extended with a strong second day, but now it's appearing to run out of gas.

The last two breakouts to new highs (in early April and then again two weeks ago, on May 12), saw the S&P 500 index hold on to those new levels for only two or three days before slipping back down and re-entering the trading range that has been in existence since early March. So, one has to wonder if this is the time that the upside breakout can hold.

In early April, all of the indicators weren't in bullish agreement, and the fall from the April highs was nasty and steep, taking SPX down about 85 points. But two weeks ago, the indicators were almost unanimously bullish. Even so, the new highs couldn't hold, but the decline in mid-May was much more shallow than it had been in April. Now, we see the indicators almost unanimously bullish again - lacking only the standard equity-only put-call ratio, which is very, very close to a buy signal at this time. The potential problem is that the market is overbought in a number of ways. That always seems to be the case when SPX struggles to these new highs, and it is often what causes the buying to dry up. However, there is a potential set of buyers this time - the shorts.

There are so many negative traders on TV and quoted in the media, blogs, and newsletters, that - if they are indeed doing what they are saying - they would have to be potential sources of short-covering with the market pushing into all-time new high territory.

Equity-only put-call ratios have been operating on split signals for about a month. The standard ratio has been rising, indicating heavy put buying, and thus has been on a sell signal. The weighted ratio has been falling for the last month, though, indicating that more dollars are being spent on calls than on puts. Thus, the weighted ratio has been on a buy signal.

What's been causing this, in my opinion, is hedging. Hedgers are buying a lot of out-of-the-money puts (which trade at low actual prices) as protection. That has been attractive, in part, because of the low implied volatilities available for option buyers these days. So there is a lot of put volume, which causes the standard ratio to rise, but these low-price puts aren't costing a lot, so there hasn't been a big increase in the dollars being spent on puts.

On the other hand, institutional traders are using a stock substitution strategy. That is, with calls being cheap, they're selling out (some of) their stocks and instead buying in-the-money calls as a replacement. This limits their risk to the striking price of the calls and frees up cash. So, they're spending a lot of dollars on these in-the-money calls, causing the weighted ratio to fall. Moreover, speculators and trend followers are buying calls as well, following the market higher since the lows in early April. These traders tend to buy at-the-money calls, again putting more dollars into calls.

After the breakout to new highs, there's been an increase in call buying, and so the standard ratio is very near to rolling over to a buy signal. If it does, that could come as soon as today, and it would then put all of our indicators into the bullish column.

Market breadth has been an accurate indicator in the past few weeks. That is often the case when the market is in a trading-range environment, as it has been. Both of the breadth oscillators that we follow are on buy signals now. It is true that they have moved into modestly overbought territory, but when a new bullish leg starts, it is desirable and important for the breadth oscillators to become overbought. It indicates that the rally is strong and broad. Another breadth indicator that we have researched recently is what we call the 'oscillator differential.' That has given a series of buy signals, the last of which was last Wednesday, May 21.

The fourth indicator that we follow is volatility. This is getting more scrutiny of late, as everyone seems to have a position in, or an opinion about, volatility. One thing we can say for certain is that the volatility indexes, CBOE Short-Term Volatility Index (VXST), CBOE Volatility Index and CBOE S&P 500 3-Month Volatility Index , are low. That's an overbought condition - but it's not (yet) a sell signal.

Volatility can remain low for long periods, just as a market can remain overbought at length. Keynes' famous saying, about the market remaining irrational longer than you can remain solvent, is a tribute to overbought markets that continue to rise (or oversold markets that continue fall). Hence, the market can continue to rise with these volatility indexes at very low levels. The time to worry is when VIX begins to trend higher. In that regard, if VIX were to rise above 14, then it would be time for concern.

But in the booming discussion of volatility that is taking place these days, I don't think I've ever seen more technical blogs, papers, and system studies about shorting volatility - which has to be done through derivatives such as futures or options (although one could sell individual index and stock options to accomplish a similar effect). The trade of, say, shorting VIX futures a couple of months out and watching them expire much lower as they drift down to the price of VIX, has been a generally winning one since the end of 2011. It was even more popular from the inception of VIX futures in 2004 through mid-2007. After that, bad things began to happen to volatility sellers, but those who were nimble enough got out of the way before the extreme volatility explosion of 2008.

Blogsters and others have pointed out that volatility is low in bonds, Forex, junk bonds, and just about everything else. Is this real complacency, or is the Fed's systematic reduction of risk in the markets (by buying up everything there is), just leading to very low actual volatility? The worriers are saying that it's complacency, and that we should prepare for Armageddon. Others are saying that volatility remains low for long periods, and that the current market state could last for quite a while.

Our take is that it's OK to short volatility, but one must hedge himself. Of course, as we noted above, if volatility begins to trend higher, then all bullish bets - including the volatility short - are off.

Finally, with VIX so low, the construct of the VIX futures has a decidedly bullish shape. The futures are all trading at a premium to VIX, and the term structure slopes rather steeply upward. Those are bullish signs, confirming the continuing bull market, as they have done since the end of 2011.

In summary, the outlook is now solidly bullish, although overbought conditions - especially the low volatility indexes - indicate that a sharp, but likely short-lived correction is possible at any time.

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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