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.

Study of 1998 and 2010 US Market Corrections

Studying 1998 correction using S&P 500.  The correction started July 20, 1998 at 1190.58, ended on Oct. 8th, at 923.32, the drop was 22.4%.  The correction lasted 80 calendar days.  The theme associated with the correction was Russian financial crisis and investors' flight to safety.  The correction was preceded by 2 years of bull market gain of 89% without a more than 10% correction.  The market rose from 626.65 on July 24, 1996 to 1184.1 on July 20, 1998 on closing basis.  After the correction, the market rose 29% in less than 2 months with 10 DMA as trend line.

Take a look at bull market from March 2009 to April 2010, in 13.5 months, S&P gained 80% from 667 on March 9, 2009 to 1217 on April 23, 2010 without more than 10% correction.  The theme with this correction was European debt crisis and investors' flight to safety.  So far, this correction looks like 1998 one.

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.

S&P 500 Chart Analysis

The S&P 500 neck line of March 09 head and shoulder bottom was 950, indicating the price target being 1233, the market's intermediate top on April 26th was 1219.8, just a few points below the target.  Then we know the market violently crashed about 10% in next 2 weeks ended on 1110.88 on May 7th.  The question is whether this is end of rally or is it a deep correction? 

Signs supporting correction include:

• The rally started last March didn't experience any correction deeper than 10%, which opens up possibility of a 10%+ correction
• This correction may be similar to Jan correction in the fashion that it breaks rising wedge formation and forms a less upward sloping new rising wedge.  
• April 26th market top was very close to, but has not reached price target of inverse head and shoulder pattern
• VIX spiked too fast (almost 200% increase in 2 weeks) which is comparable to what market experienced in late 2008, however, US economy now is in much better form than that of late 2008
• As of April 27, Bull/Bear spread (Investor Intelligence bullish sentiment minus bearish sentiment) is reaching towards 40 danger zone, but has not yet arrived there yet. For more details, see here.

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.

Forecast of When This Correction will End based on History

Based on history, I predict this correction which started April 16th led by financials will end either on May 7th or May 14th, both are Fridays.

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

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