Ascending Wedge Formation Analysis

In the post bear market rally that began March 2009, major US market stock indexes have been rising in the pattern of ascending wedge formations.  A couple of wedges with less bullishly tilted angle can be drawn to confine variance stage of bullish runs of three major indexes.  For S&P 500, tipping point of past wedges have been reached, however, NASDAQ and DJIA failed to reach tipping points of past wedges.  This suggests that S&P will likely reach 1300 tipping point of the current wedge. 

S&P 500

NASDAQ

Dow Jones Industrial Average

2010/4/27 Update

Since the post was initially put up  on 4/21, the market went up a little, S&P 500 touched 1219.8 then broke down ~2.3% on 4/27, on the same day, VIX spiked 30%.  With the upper edge of this formation confirmed, if the lower edge holds, the apex tip of the rising wedge is a little bit over 1300 around September time frame.   Whether the lower edge will hold depends on where this correction will end.  One sign that this is a correction instead of THE top is that PPO on weekly chart is showing higher high.  

S&P 500's rising wedge formation as of 4/29

 

S&P 500 Chart with Bollinger Band

Here is an updated chart of NASDAQ's rising wedge formation (as of 4/29)

One interesting note about NASDAQ is if you look at the weekly chart with Bollinger Band overlay, Bollinger Band's parameters are 20,2, you will see that index has gone over-extended in a similar fashion as it did back in mid-September 2009.  At that time, it took 1.5 months for the index to trade sideways to allow Bollinger Band to catch up before it resume uptrend to gain around 300 points.  With the rally target around 2800, around 300 points away from current level, I expect either the index to trade sideways for 1.5 months or retrace at least 5% back to median of Bollinger Band before it resumes final rally to 2800.

Here is an updated chart of DJIA's rising wedge formation (as of 4/29)

DJIA chart with Bollinger Band

US Stock Market Correction Forecast and Outlook of Major Stock Index

In early 2010, many people took bearish stances on US stocks, the correction started on Jan 19th caused many to believe that the stock market top of the year is in, however, the 9% correction ended abruptly in early February, what's more surprising and unexpected was the following powerful rally that lasted more than 2 months: NASDAQ rallied 15.5%, S&P 500 rallied 12.7%, DOW rallied 11.1%.  Just as investor sentiment became vastly bullish and market turned overbought (defined as RSI70 above 70) for more than a month, on April 16th, market tumbled 1+% on extremely high volume (S&P over 6B), putting the powerful rally to a squeezing stop.

I believe there are two possible scenarios mid term if 4/16 was indeed start of a correction.  Scenario A is more favorable to bullish investors, it assumes the supporting trend line from March 09 low to Feb 10 low (blue lines) to hold until August.  Scenario B, on the other hand, doesn't take such a bullish stance.  We notice that this post bear market rally can be split into two rallies characterized by two supporting trend lines: one from March to this January, the other from this Feb to April 16th, the second rally is powerful yet it's sitting on a trend line (blue lines) less bullishly tilted than first (pink lines). This fact caused me to draw a Scenario B where we will have a third as well as last part of this rally which just like the one from Feb to April, will sit on a trend line (green lines) even less bullishly tilted.  I must admit the third supporting trend line is totally fictional, by drawing that line, I am indicating the existence of this trend line is possible.  Based on this understanding, the following charts illustrate my forecast of S&P 500, NASDAQ and DOW in the mid-term (click on images to read my comments).
S&P 500

NASDAQ

 
 DOW JONES

Fed Tightening Cycle vs. S&P 500 Corrections, From Timing Perspective

There was a consensus view that stock market tends to trade sideways before the Fed tightening cycle begins. Based on that view, earlier in 2010, many analysts predicted the first half of 2010 will see volatility rise in stock market, and major indices will trade sideways. Morgan Stanley predicted that in 2010 stock market will behave in similar ways as 1994 and 2004, in both years Fed stopped expansionary fiscal policy by starting to raise Fed funds rate.
Comparing with 1994 and 2004, 2010 shares strong economic recoveries reflected in the form of improved corporate earnings, however, 2010 suffers a much higher unemployment rate (9.7% ytd vs. 6.1% in 1994 vs. 5.5% in 2004). What's more, unemployment is expected to remain high for an extended period of time. Based on history, Fed wouldn't start tightening cycle before unemployment rate drops below a certain level. So it's possible for Fed to keep rates at near zero level for extended period of time. If that's happening, how will stock market behave then? To answer that question, I decided to take a look at the relationship between Fed tightening cycle and stock market performance from timing perspective. The discoveries are interesting.
In 1994, Fed started to raise rate in February, almost at exactly same time, the stock market started to correct. After a 9% correction, S&P traded sideways until November, then staged next leg up for new highs.

In 2004, unlike 1994, S&P 500 started correction well before (5 months to be exact) Fed started tightening cycle. The full correction lasted about half a year and registered ~8% drop from top of the previous rally to the bottom of correction, and the period lasted ~6 months.

So to answer the question of whether stock market will enter the correction stage with high volatility right when Fed starts tightening, the answer is no, stock market may start to correct well before the Fed tightening cycle starts. It took 10 years for US economy to go from one recession to the next one last time, this time it took only 6 years. In previous recovery, S&P 500's correction preceded Fed tightening cycle by 5 months, in this recovery, this time window may be longer, in other words, S&P 500 may start correction more than 5 months before Fed starts tightening.   All the interesting historical facts indicates that US economic growth are increasinly dependent on Fed's expansionary fiscal policy which are like drugs relieve addicts for the short term but not healthy to them in the long term, as a result, recessions happen more frequently, and in each recession, Fed needs to take longer time (increase the dose) before it could start tightening.
S&P 500 reached 1150 on Jan 19, then corrected to intra-day low of 1044 in early February, now it's back to 1150. Based on history, I feel hard to believe S&P 500 remain in rally mode after this point since it's likely we are only 2 months into the 6-8 month sideway trading period.
 
Disclosure: author long SDS, QID and DXD at time of writing