Are markets predicting an Obama victory?
The typical cycle suggests a pullback is coming heading into the election, but it could be more severe if Romney wins.
By Dave Moenning
Although bears may contend that stocks are overbought, that sentiment is too upbeat. It seems the market is a single headline away from a major downtrend.
These days, different indicators point to different directions. The breadth thrust buy signal, one of our favorite market indicators, tells us that the odds favor the bulls in the coming months. But the history of the cycle composite (a combination of the one-year seasonal cycle, the presidential cycle, and the 10-year market cycles) suggests that a pullback over the next month or so would be in keeping with historical trends.
However, I thought I'd dive a bit further into the cycle work to see if the presidential election cycle has anything meaningful to offer. In our research, we took a look at how the market -- SPDR S&P 500 (SPY) -- acted in all the elections since 1900. We looked at cases where the incumbent party won the election and when the incumbent party lost.
We also reviewed the outcomes of the elections relative to the performance of the stock market prior to the election and compared all of the above to the current election cycle.
The good news is that the Dow Jones Industrial Average ($INDU) tends to produce solid gains during election years. In a typical cycle, stocks go sideways in the first quarter of the year, rally into May, correct into July, rebound strongly into September, pull back a bit into early October, and then enjoy the usual year-end rally.
However, when the incumbent party loses the election, the early year rally tends to fizzle quickly and the summer correction is more pronounced. The decline in September and early October tends to last longer and be much more severe, and the typical year-end rally never really gets going, leaving the Dow lower for the year.
In looking more closely at the September-October period of each cycle, it becomes clear that the stock market tends to favor an outcome that doesn't change things politically. While there is usually a pullback during September in a presidential cycle -- regardless of which party wins -- when the incumbents win the pullback tends to be much shorter and far less intense than when the incumbent loses.
In fact, history shows that if the incumbent party winds up retaining the White House, the September declines end before the end of the month, giving way to a meaningful rally that lasts into early December.
There is one additional bit of historical data worth considering before investors place their bets on the outcome of the election. Remember that the stock market hates uncertainty and tends to discount the future.
We found that when the DJIA has sported gains of more than 8.5% through the end of August, the incumbent party has mostly won the election. In fact, since 1900, when the DJIA has sported a gain of 8.6% or more through late August, the incumbent has lost on only three occasions.
With the DJIA currently up nearly 11% year to date, the S&P 500 ($INX) is up almost 16%, small caps -- Russell 2000 Index (IWM) -- are up 15%, and mid caps -- S&P MidCap 400 (MDY) -- sport a gain of just about 15%. The NASDAQ (QQQ) has gained an impressive 24%, thanks in no small part to Apple (AAPL). The stock market would appear to be casting its vote early -- at least from a historical perspective.
So let's review. The recent "breadth thrust buy signal" tells us that stocks have rallied nicely in the months after the signal. But the "cycle composite" suggests that it's time for the market to pull back. Finally, the presidential cycle suggests that the severity of the sloppiness typically seen in September will depend on who wins the election.
If the Democrats retain the White House, any pullback should be short and shallow. But if the Republicans win, stocks may actually suffer into the election.
For more on the State of the Markets, visit www.StateoftheMarkets.com. FollowMoenning on Twitter: @StateDave
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Stocks drift lower and bonds are hit as investors await the Fed. Prepare for higher volatility this week.
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