An options volatility tracker has produced a 'spike peak' buy signal for stocks for the first time in months, at a time when internal market indicators are negative

Stock market internals are bearish but a key volatility reading is bullish.

You can't always grade the stock market on a curve. If you did, the current market would likely fail, and prices would be much lower.

Readings of market breadth, which take into account how the majority of stocks are performing, rather than just those in major indexes, are negative on many fronts. And yet, even with higher oil prices and higher interest rates, both seen as harmful for stocks, the benchmark S&P 500 index SPX is only a little more than 2% below its Aug. 13 record close.

And a recent development in the options market has even produced a buy signal.

Breadth has been a problem for this market for a long time, but it has now become a more severe problem. What I'm referring to is simple breadth - the number of advancing issues minus the number of declining issues. The strong S&P 500 rally over the past 16 months or so has been led by a relatively narrow group of artificial-intelligence-related stocks. Many other stocks are not doing as well.

On Friday, although the S&P 500 closed up 0.2%, nearly two-thirds of its component stocks declined, according to FactSet data.

Meanwhile, volume breadth - the volume of advancing stocks minus the volume of declining stocks - has been more in tune with the market rally because of the heavy volume in those AI-related stocks.

In any case, simple breadth technical indicators have been flashing sell signals for stocks for some time. Now they have worsened to the state that they are in deeply oversold territory, which might suggest a bounce may be needed before declines can resume.

But "oversold does not mean buy." Yes, there could be sharp, countertrend rallies, but these breadth indicators will not improve to buy signals until there are at least several days of positive breadth.

Another indicator of market internals is the number of new highs, or stocks that reached their highest prices seen over the past year, compared with the number of stocks hitting new lows on the New York Stock Exchange.

This indicator generated a sell signal on Sept. 1, and that has remained in place ever since. At Friday's close, new lows have beaten new highs for 14 sessions in a row. On some of those days, new lows have totaled well over 300 issues.

That is a large number considering that the S&P 500 is only down a couple percentage points from its all-time high. It essentially means that a good number of stocks were hovering just above their yearly lows even though the S&P 500 was near its yearly high. That is a negative internal picture, to be sure. This indicator will remain negative until new highs outnumber new lows for two consecutive days on the NYSE.

On Friday, stocks hitting new lows outnumbered those reaching new highs 189 to 34 on the NYSE, according to FactSet data.

So all of these "internal" indicators are negative at this time. One would think that would be enough to force the S&P 500 to fall through market support.

There are some parts of the options market that are painting a negative picture, such as the ratio of put options purchased, or bets that the market will decline, over the number of call options purchased.

But the market hasn't been trending lower, because the volatility space remains quite bullish. Volatility is an important input in how options are priced, as it provides traders with an idea of the likelihood that target prices will be reached.

The Cboe Volatility Index VIX, which tends to rise when the market falls and vice versa, is still not buying the bearish case. The VIX probed up to an intraday high of 18.94 on Wednesday but then backed off.

It still has not closed above its 200-day moving average, a widely followed chart indicator that many view as a dividing line between uptrends and downtrends. It has traded above the 200-DMA intraday, given all the recent volatility associated with rising oil prices and interest rates, but has not closed above it.

On Friday, the VIX closed at 14.87, while the 200-DMA came in at 18.09.

Instead, the VIX has been in a "spiking mode." That means it spiked up at least 3.00 points over a three-day or shorter time period, using closing prices. The highest price that it reached so far is 18.94, which is 3.10 points above the Sept. 11 close of 15.84. So the fact that the VIX erased that spike by closing at 15.44 on Thursday, and by falling below 15 on Friday, means it produced a new "spike peak" buy signal for stocks.

We haven't seen a "spike peak" buy signal since early last June - an extraordinarily long time for VIX to go without spiking upward on some negative news or rumor of some sort.

Basically, as the market meanders just below record highs, the internal indicators remain very negative but VIX indicators remain positive. This is about as confounding as you can get.

If the S&P 500 closes below 7,580 for two consecutive days - it closed below that level on Wednesday but bounced back above it on Thursday - that's when the bears will take control. Lacking that, the bulls still have a chance to dominate the action.

New recommendation: APA Corp.

The rally in APA's stock (APA) that began in July has been a strong one that has engendered a lot of call option buying. Too much, in fact, as this contrarian indicator has now generated a sell signal. The sell signal is denoted by green "S" on the accompanying chart.

In essence, the ratio has formed a local minimum on its chart and is now trending upward. As long as the put-call ratio is rising, that is negative for the energy company's shares.

Buy 3 APA (Oct. 16) $45 puts in line with the market.

We will hold these puts as long as the weighted put-call ratio for APA remains on a sell signal.

Send questions to lmcmillan@optionstrategist.com.

Lawrence G. McMillan is president of McMillan Analysis, a registered investment and commodity trading adviser. 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 adviser and with the CFTC as a commodity trading adviser. 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