The stock market's cruel summer is about to get much worse

By Lawrence G. McMillan

Bears control the S&P 500 now. Plus: This small stock trades like it could have big news

A move back above 5,585 for the S&P 500 would be bullish, but the new trend is bearish - at least for the short term.

The S&P 500 index SPX has quickly turned down from its all-time highs. In fact, a pattern of lower highs and lower lows has already emerged, which is quite bearish. We are no longer recommending a "core" bullish position, and we are acting on new sell signals.

How did this happen so quickly? SPX made new all-time highs in the first half of July, and there was no negative divergence in place. In fact, small caps were beginning to come alive for the first time in quite a while. Even now, with SPX having broken support, the small-cap indexes are outperforming (although they are also falling).

SPX bounced off of support at 5,500 on July 19. At that point, the bulls had the opportunity to regain control, which would have come in the form of SPX trading to new all-time highs. Instead, that rally failed, leaving a lower high in place. Then, on July 24, SPX broke down through the entire support area at 5,440-5,490, and thus established a lower low by doing so. We now have a pattern of lower highs and lower lows, and that is the hallmark of a bearish market. A move back above 5,585 would be bullish, but the new trend is bearish, at least for the short term.

The recently-established McMillan Volatility Band (MVB) sell signal is in place. Its target is the -4<SIGMA> "modified Bollinger Band" (mBB), which is currently at 5,360 and falling. This signal was just confirmed a week ago, on July 18, and is marked with a green "S" on the accompanying SPX chart.

Equity-only put-call ratios have turned bearish as well. The weighted ratio turned sharply higher about a week ago, and now it has been joined by the standard ratio. These will remain bearish for the stock market as long as they continue to rise.

Market breadth had improved tremendously when small caps joined the bullish party in the first half of July. However, conditions have deteriorated. Both breadth oscillators have now fallen into bearish territory; that just happened on July 24, and we require two-day confirmation of any new breadth-oscillator signal. So, unless breadth is tremendously positive on July 25 (unlikely), these oscillators will turn bearish for stocks as well.

One bullish area that remains is new highs vs. new lows on the NYSE. That indicator continues to remain on a buy signal for stocks, since new highs continue to outpace new lows by a wide margin. This buy signal would be stopped out if new lows were to outnumber new highs on the NYSE for two consecutive days.

Realized volatility has chimed in with its own sell signal. The 20-day historical volatility of SPX (HV20) had fallen to as low at 7% during the breakout to new all-time highs in early July. But now it has risen to 13%, and that is a sell signal. This sell signal will remain in place until HV20 falls back below 9%.

Implied volatility, in the form of VIX VIX, has suddenly taken notice of this new bearishness as well, as it has spiked higher. First, since VIX closed above its 200-day moving average (MA), that stopped out the previous trend of a VIX buy signal (marked with a square on the accompanying VIX chart). That is not a sell signal but merely a return to a neutral status for this indicator. For a sell signal to occur, the 20-day MA of VIX would have to cross above the 200-day MA. As one can see from the VIX chart, the 20-day MA is now rising rapidly, so that crossover might happen soon.

On a more bullish note, VIX has now entered "spiking" mode. A "spike peak" buy signal (for stocks) will eventually occur, and that will happen when VIX closes at least 3.0 points below the highest price that it has reached while in "spiking" mode. Currently that high is 19.04, reached overnight on July 24. So, this is a potential bullish signal setting up, but it is not complete yet.

The construct of volatility derivatives remains bullish in its outlook for stocks. August VIX futures are now the front month, so one thing we will watch for a warning sign is if August futures were to trade above September VIX futures. That has not happened. In fact, the term structures of both the VIX futures and of the Cboe Volatility Index continue to slope upwards, and that is bullish for stocks. These term structures have flattened somewhat, though, so this is an area that we are watching closely.

With the breakdown on the SPX chart, we are no longer recommending carrying a "core" bullish position. We will continue to trade any confirmed signals as they occur.

New recommendation: Equity-only put-call-ratio sell signals

As the equity-only put-call ratios begin to rise, that is bearish for stocks. Both ratios are now on sell signals, so we want to take a position based on that:

Buy 1 SPY SPY Sept (20th) at-the-money put and sell 1 SPY Sept (20th) put with a striking price 40 points lower.

This position will remain in place until these ratios roll over and begin to trend downward.

New recommendation: Emergent Biosolutions (EBS)

Emergent Biosolutions Inc. (EBS) is bucking the trend of the market and is advancing strongly. There hasn't been any specific news, but the stock and option volume figures have surged. In fact, the options are quite expensive - often a sign that news is about to be released. The simplest approach would be to merely buy the stock, thus avoiding the large time-value expense in the options. Another approach would be a call bull spread, which is appropriate when options are overpriced.

Buy 2 EBS (Sept. 20) 12.5 calls and Sell 2 EBS(Sept. 20) 20 calls for a debit of 2.40 or less.

The maximum price that this spread could reach is 7.50 - the difference in the strikes. Initially, we will set a trailing stop at $10.70 for this position.

New Recommendation: Walgreens Boots Alliance (WBA)

This a longer-term potential buy signal from Walgreens Boots Alliance Inc. (WBA). We are keeping this recommendation open but will not continue to reprint the reasoning behind the trade, other than to say that stocks that have been removed from the Dow Jones Industrial Average DJIA usually experience a strong rally within a matter of weeks after that removal.

WBA was obliterated after its latest earnings report. The potential MVB buy signal was canceled. So, we adjusted our entry points:

If WBA closes above 13.10, then Buy 2 WBA (Aug. 9) 13 calls in line with the market.

Follow-up actions:

All stops are mental closing stops unless otherwise noted.

We are using 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 0 INSG (Aug. 16) 11 calls: These calls were stopped out when INSG (INSG) closed below 10 on July 19.

Long 1 expiring SPY (July 26) 561 calls: This is our "core" bullish position. It has been rolled up a couple of times. Allow it to expire and do not replace it.

Long 5 CORZ (CORZ) (Aug. 16) 11 calls: Raise the trailing stop to 9.60.

Long 0 INOD (Aug. 16) 20 calls: These calls were stopped out when INOD (INOD) closed below 17.50 on July 24.

Long 2 FIVE (FIVE )(Aug. 16) 75 puts: After rolling down for a substantial credit, we are holding without a stop for now.

Long 2 NKE (Oct. 18) 75 puts: Hold as long as the put-call ratio for NKE (NKE) remains on a sell signal.

Long 1 SPY (Aug. 16) 555 calls and short 1 SPY (Aug. 16) 570 calls: This position was established at the close of July 5, when new highs on the NYSE numbered more than 100. It would be stopped out if on the NYSE, new lows exceed new highs for two consecutive days.

Long 2 AKAM (Sept. 20) 90 calls: This position will be held as long as the AKAM weighted put-call ratio remains on a buy signal. If AKAM (AKAM) trades at 100, then roll up to the (Sept. 20) 100 calls.

Long 1 UNP (UNP) (Aug. 16) 245 call: We will hold as long as the weighted put-call ratio remains on a buy signal.

Long 1 CRM (Aug. 16) 250 put: The trailing stop remains at 262. Sell the put if CRM (CRM) closes above 262.

Long 1 SPY (Sept. 20) 553 put and Short 1 SPY (Sept. 20) 523 put: This spread was bought for the MVB sell signal when SPX traded at 5,572 on July 18. Its target is for SPX to trade at the -4<SIGMA> Band, which is currently at 5,360 and falling. The trade would be stopped out if SPX closes above the +4<SIGMA> Band, which is currently 5,750 and rising.

Long 2 RHI (Sept. 20) 65 calls: We will hold these as long as the weighted put-call ratio of RHI (RHI) remains on a buy signal.

All stops are mental closing stops unless otherwise noted.

Send questions to: lmcmillan@optionstrategist.com.

Lawrence G. McMillan is president of McMillan Analysis, a registered investment and commodity trading advisor. McMillan may hold positions in securities recommended in this report, both personally and in client accounts. He is an experienced trader and money manager and is the author of "Options As A Strategic Investment." www.optionstrategist.com

(c)McMillan Analysis Corporation is registered with the SEC as an investment advisor and with the CFTC as a commodity trading advisor. The information in this newsletter has been carefully compiled from sources believed to be reliable, but accuracy and completeness are not guaranteed. The officers or directors of McMillan Analysis Corporation, or accounts managed by such persons may have positions in the securities recommended in the advisory.

-Lawrence G. McMillan

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