Market Moves in 2010: Elections and the Fed Could Produce a Good Year

Predictions about the stock market's performance should always be taken with a grain of salt, since no one I've met yet can actually see the future. But with the proper spirit of humility, looking at potential scenarios can be a useful exercise. Humble attitude firmly in place, I offer up a sketch for the Dow in which the market moves up, then down, then up again in 2010.I have prepared a chart (below) to depict the scenario, which is based on several key technical analysis patterns and an awareness that this is an election year.

Why are elections important? As I have indicated on the chart, stocks tend to rise prior to elections. The reason is fairly obvious. The politicians holding the reins of power wish to continue to do so, and so they do everything in their power to promote a sense of financial improvement to boost their chances for re-election.

As others have noted, various government officials have suggested that supporting the stock market is a cheap way to create a "wealth effect" in the populace, and a rising stock market tends to make people feel richer, even if the actual increase in their portfolios is modest.

The Fed Does Its Work

Though Federal Reserve and Treasury officials are not elected, they do serve at the behest of elected politicians, and thus they are not immune to pressures to boost the economy in election years. Indeed, there is already talk of another round of Federal Reserve purchasing of mortgage-backed securities (MBS) to support the housing market. Fed purchases of MBS -- at $1.2 trillion, one of the largest Fed quantitative easing programs -- were scheduled to wind down early in 2010.

Another round of Federal stimulus spending is also probable as Congress will be tempted to open the spigots in support of "job creation" or forestalling the insolvency of numerous state governments.

Regardless of the specific causes or programs, it is easy to see that the market tends to rise prior to elections. (The time to call for "belt-tightening" and "sacrifice" is of course after one has safely won re-election.)

A Classic Head and Shoulders

The first technical analysis pattern we observe in a long-term chart of the Dow Jones Industrial Average DJIA (which I am using as a proxy for the U.S. stock market, though the Russell 2000 is a much broader index) is a multi-year "head-and-shoulders" formation.

As with any chart pattern, head-and-shoulders sometimes reside mostly in the eye of the beholder, but this one is strikingly obvious. Stocks climbed sharply in 2006 to reach what looks like a classic "double top" formation in 2007, at which point the market fell in a descent that was roughly symmetrical to the ascent (the two "shoulders").

The global financial crisis then caused the market to fall precipitously in 2008, reaching a nadir in early March 2009. Global governments' unprecedented stimulus and quantitative easing sparked a massive V-shaped rally, which continued with only minor interruptions in July and November to the present. The head-and-shoulders pattern often marks a major top in the market, so this offers a formidable technical obstacle to those calling for new highs.

The stock market is considered a discounting mechanism which supposedly looks ahead six months to assess future risks and returns. This sharp 10-month rally in most major global stock markets has been based on the expectation that the tremendous stimulus spending and credit easing engineered by governments will trigger a global economic recovery.

A New Pattern?

While the signs of recovery continue to be mixed, the market started the year on a tear. And that takes us to the second technical pattern, a potential A-B-C-D move.

Many technicians have observed that markets tend to rise and fall in a three-leg pattern marked by four points (ABCD). The A to B leg is the initial move -- in this case, it's the strong up move from the March 2009 lows.

At some point -- often a Fibonacci projection or other technical level of support or resistance -- the first leg reverses as nervous traders take profits and some doubts about the sustainability of the first move seeps into the market. This is the B to C leg, or the healthy correction in an uptrend which removes excess speculation and weeds out weak hands who prefer to take profits or lower their risk by selling.

The 50% Fibonacci retracement of the Dow Jones Industrials -- the point at which the index has regained 50%of its total decline from the 2007 highs to the 2009 lows -- is about 10,335, a level the DJIA has exceeded by a comfortable margin. The next retracement, according to the model, is to the 61.8% level, which is around 11,245. With the DJI hovering around 10,550, that's only 6.6% (700 points) away. (The 50% retrace level for the S&P 500 index is 1,121, while the 61.8% level is 1,228.)

With the rally getting long in tooth (10 months without a correction is on the long end of typical rallies) and the key Fibonacci levels already surpassed or close at hand, many old trading hands sense it's about time for a B to C correction.

Thus we can anticipate the current rally running out of steam, perhaps as early as mid-to late January. What might trigger the downleg is unknown, but investors anxious to lock in profits could decide to sell now and ponder fresh data later.

The Next Rise

After the correction bottoms out in a month or two, then the ABCD pattern anticipates a second leg up as confidence returns, perhaps as a result of a second round of government stimulus in an election-year bid to renew voter enthusiasm. This second leg generally matches or exceeds the length of the first leg.

This is of course a highly speculative guess, and it is based on the observations of an amateur (me). The precarious global economy could easily suffer another credit-contraction or default shock, or some other financial event could trigger a major global downturn.

Nonetheless, history suggests the party in power will move Heaven and Earth to boost the stock market and hence their chances for re-election in November. Barring any surprise shocks, the "global recovery story" could well continue up to the election -- at which point new doubts may take hold of the market.
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