Midterm elections are great for the stock market, regardless of who wins. But the divided government that emerged this year is even more optimistic.
Compelling seasonal factors also tell us now is a good time to buy stocks. Here are more details and eight companies to consider.
1. The Effect of the Midterm Elections, Part 1
It’s no secret that there is a quiet battle between the financial world and the political sphere over who matters most. In a blow to Washington, DC, in this contest, Wall Street loves when the Capitol is neutralized by divided power. When one party controls part of Congress and the other has the White House, the implied stalemate means politicians can do less damage, according to this logic.
“A Democratic president with a Republican Congress is the best configuration that has appeared in the last 90 years,” says Patrick Nielsen, deputy chief executive of MAPFRE AM, an investment group.
The market risk is that given the heightened political polarization, we end up with market-damaging battles over issues such as raising the debt ceiling or using fiscal stimulus in a recession, says Nielsen .
2. The Effect of the Midterm Elections, Part 2
Historically, midterm elections have put together beautiful rallies with phenomenal regularity. Since 1942, after the midterm elections, the S&P 500 SPX,
rose 7.6%, 14.1% and 14.9% over the next three, six and 12 months, notes Ed Yardeni of Yardeni Research. This is regardless of the outcome of the elections.
The two graphs below show the history. Areas shaded in green and red represent the 12 months following an election. The percentage of market movement over the three, six and 12 month periods is written below the election year.
“In midterm elections, you normally see a major dip in the fourth quarter,” says Paul Schatz, founder and chairman of Heritage Capital. “The market is currently in a bottoming process. It’s hard to deny that. This could lead to a significant market rally.
Here is more evidence of this bullish election year effect. Over the past 10 years, the CBOE VIX Volatility Index,
fell 5% to 45% in November for an average decline of 20.4%, points out Lawrence McDonald of the Bear Traps Report. A falling VIX means investors are calming down, a change in mood that correlates with rising stock values. So far in November, the VIX is down 7%, so the effect may already be underway.
3. October is a bear market
“October has a reputation as the biggest killer of bear markets,” says Schatz, at Heritage Capital. Twelve of the post-war bears died in October.
Why is it?
One reason could be that October is the tax-loss selling deadline for institutional investors. My own theory, backed by research from both hemispheres, is that cold weather brings out a “prepare for tougher times” mentality that drives investors to harvest money, just like humans harvest food. in autumn for eons.
Whatever the reason, seasonal clearance creates good business.
“There are more opportunities today than I’ve seen since the fourth quarter of 2008,” Schatz says.
I’m not a huge fan of technical analysis, but interestingly, there was an engulfing uptrend on October 13th, which was the recent low in the market. In this pattern, the one-day trading range “engulfs” the previous day’s trading range, and it is bullish when it closes near the high of the range. Think of it as a final battle between bulls and bears in which the bulls win and the bears concede victory.
“The odds are definitely in favor of a major fourth quarter low,” says Schatz, who also noticed this technical signal.
4. Santa is real
The period from November to January is seasonally strong for the market. Since 1936, the S&P 500 has risen 4.5% against an overall three-month average return of 2.9%, Bank of America quantitative analysts tell us. Moreover, this period only had negative returns 24% of the time, the lowest of any three-month period other than October-December (19% of the time).
Yardeni finds that, since 1928, the S&P 500 has risen 0.5%, 0.6% and 1.4% on average in October, November and December. “Yes Virginia, there is indeed a Santa Claus rally”, he concludes.
This chart shows performance by month, since 1928, but is more pronounced during midterm election years.
November is the best month of the year for the Nasdaq COMP,
during midterm election years, 3.5% return since 1971. The six months from November to April generated an average return of 7.5% on the Dow Jones Industrial Average DJIA,
against an average gain of 0.8% from May to October.
What could trigger a rally
A rally is not far-fetched, for three reasons.
1. The feeling became extremely dark, as I wrote here. It’s generally best to buy when things look bleak, not when all is rosy. This is because the market is a forward-looking discounting mechanism. “The majority is almost always wrong at the extremes, and we’re at the extreme now,” says Schatz. “If people are waiting to feel really good, markets will be 20-30% higher from here.”
2. Inflation will come down soon as the upstream price indicators are all down. This will cause the Federal Reserve to signal that it may forgo raising interest rates. You can already see hints of this, if you squint. While Fed Chairman Jerome Powell remains hawkish, Fed Vice Chairman Lael Brainard has adopted a more dovish tone in his speeches. “Brainard thinks the Fed may have done enough, or soon will, to bring inflation down, given that the impact of cumulative tightening on the economy operates with lags,” Yardeni said. We will know more about prices on Thursday when the Consumer Price Index (CPI) is released.
3. We could see a soft landing for the economy. While many people remain convinced that we are going into a recession that could further squeeze stock indices, that may not be the case. Goldman Sachs economist Jan Hatzius says there is still a “very plausible” chance that we will avoid a recession despite the Fed’s aggressive tightening campaign. He puts the chance of a recession over the next 12 months at 35%. Similarly, Yardeni puts the odds of a recession at 40% and a soft landing at 60%.
Go long and wide
One of the easiest ways to invest, and probably the most appropriate for many people, is to invest in long-term positions in a broad basket of stocks. You can do this with large exchange-traded funds (EFTs), such as the Schwab US Broad Market ETF SCHB,
iShares Core S&P Total US Stock Market ETF ITOT,
and SPDR Portfolio S&P 1500 Composite Stock Market ETF SPTM,
If that is your strategy, step up your buying at times like this when the sentiment is so bleak.
Prioritize damaged goods
You might think that in troubled times like this, it’s best to buy companies with strong balance sheets and excellent free cash flow. But it could be one of the worst things to do, says Schatz. Instead, the top performers are often found among the hardest hit stocks. “What goes down the most rallies the most coming out of the bottom,” says Schatz.
Indeed, stocks destroyed by the October tax-loss sale have historically outperformed, as you can see in this column.
Here’s an additional twist to this theme, which I haven’t put in this column: Those who are most down do the best. They posted 3.6 percentage points of outperformance from November to January against 1.8 percentage points for all candidates for the tax-loss sale, according to Bank of America.
Four most beaten names are two stocks rated “buy” by Bank of America: Match Group MTCH,
and Caesars Entertainment CZR,
; and Nvidia NVDA chip leaders,
and Advanced Micro Devices AMD,
To find the sidewinders
Schatz likes stocks that are hit hard but at some point stop falling each time the market dips again. They resist further selling waves and instead trade sideways.
“It shows that sellers are exhausted,” he says.
Stocks he owns in this category include the Wix.Com web development platform WIX,
and AbbVie ABBV,
and modern mRNA,
in biopharmaceuticals.
Otherwise, avoid the leadership names of the previous bull market, i.e. the FAANGs. An exception made by Schatz is Netflix NFLX,
which also withstood the sell-off decline in the market.
“I always like the best stocks that are having a hard time,” he says.
Otherwise, the rule is that when new bull markets emerge, so does new leadership. What could be the new leadership groups?
“Given the rate situation and the fact that the yield curve is going to steepen, financials will be seen as a leading group,” says Schatz.
They benefit from the rise in rates and the steepening of the yield curve. Materials stocks are another potential leadership group in the early stages of the next bull market, as they are economically sensitive.
Michael Brush is a columnist for MarketWatch. At the time of publication, it has CZR, NVDA, and NFLX. Brush suggested CZR, NVDA AMD and NFLX in his stock newsletter, Brush Up on Stocks. Follow him on Twitter @mbrushstocks.
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