Market opinion

The market may have topped or is very close to a top for the following reasons / facts:

• AAII/Retail investors' bullish sentiment is at highest level since Jan 2007
• Spread between QQQQ or Nasdaq 100 and VXN is at highest levels in 4 years
• DJIA and S&P 500 has almost reached the price target of reverse head & shoulder formed during summer correction, while NASDAQ has already reached the price target
• High yield funds are turning negative significantly on Friday for the first time in about 4 months.  Junk bonds and high yield bonds have broke down the up trend from mid-May to early November.
• Bond fund (Pimco Total Return Fund) is breaking down the 20 month up trend since March 2009 (not quite sure what's the implication of this to equity market)
• Euro/Yen is at turned down at upper end of downward channel at around 1.15 and is now heading down (see chart below)

I would put extra focus on currencies in the next week.  On my radar screen: QID, QLD puts, VXX calls, BIDU puts

Leverage Short ETF 1 year relative performance

Comparing QID, SDS, VXX and FAZ 1 year relative performance in % terms: obviously VXX is the worst performer, SDS is the best, FAZ has been performing worse than QID, but recently, FAZ started to out-perform QID.

Protective ETF chart analysis: VXX and QID

VXX

QID

Both ETFs have bottomed and booked higher low in early August comparing with the low in late April.   Together with the huge volume associated with the advance from April low, these evidences indicate the long term down trend since March 2009 for these two ETFs has reversed.

US Stock Indexes broke down from head and shoulder neckline

Major US stock market indexes broke down from head and shoulder neckline today.

• S&P 500 H&S top is 1220, neck line is slightly downward tilted at 1042 area, so price target is 1042-(1220-1042) = 864, or 16% lower than today's close 1030
• NASDAQ H&S top is 2512, neck line is slightly upward tilted at 2120 area, so price target is 2120 - (2512-2120) = 1728, or 18% lower than today's close 2109

It is imminent now to take actions to protect your portfolio if you are long stock market.

Today's Markets Do Feels Like Bottom

Black Swan event happened today on the markets, when DOW, NASDAQ and S&P 500 all falling from a cliff in the afternoon.  People are blaming machine trading and erroneous trader as the culprit of the massive tumble, Mark Fisher blamed HFT for today's event (http://www.cnbc.com/id/37002752), however, I don't agree.  If it is really caused by error, then why the market turned at the points they turned?  When the market turned, why they turned in that speed rather than slowly claw back, I do feel the markets act in its own mysterious way and logic, and what happened today is not accidental, far from an error.  I agree with Mark's comment, it is a warning and a signal of great danger ahead.  Program Trading may accelerated the fall, but I believe without machine trading, the market will do the same thing under this same circumstances.

Today's markets do remind me how they did in last March.  Their accelerating drop look very much like a left side of a giant head.  Volume was huge, for example, S&P's volume was 8.14B.  It's obvious that investors are fleeing the market, panic overwhelms, which means today is very likely capitulation day of this correction started on Apr 16th.  These are characteristics of a bottom.

If today's action is truly the head of reverse head and shoulder  formation, then price targets for the major markets are signaled:
NASDAQ's neck line is at 2420, head was at 2185, and price target after breakout would be 2670
S&P 500's neck line is at 1174, head was at 1066, and price target after breakout would be 1282
DOW's neck line is at 10941, head was at 9869, and price target after breakout would be 12013

For record of today's historical event, here are charts of today's markets
NASDAQ

S&P 500

DOW JONES

S&P 500 and NASDAQ Chart Analysis

S&P 500 is forming a viscious head and shoulder top pattern, with downward sloping neck line, and price target at around 1140.  We do see volume zoom up at the right side of the right shoulder which serves a confirmation of this formation.

Similarly NASDAQ is forming a head and shoulder pattern as well, different from S&P, its neck line is slightly upward sloping.  Its near term price target is around 2365 which is close to my price target of 2320 level.

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