As April approaches and the markets remain near record highs, it is time to take a look at the mid-term election cycle. Since 1950, it has signaled turbulence for the stock markets.
Normally, during the mid-term election cycle, the markets rally until April but the first three months of the year have been less than stellar with the Dow down almost 2%, the S&P 500 Index flat and only the NASDAQ gaining a little. Nonetheless, we have made news highs this year and we could well climb another 40 points or so on the S&P 500 before all is said and done.
However, in mid-term election years we typically get a peak in the spring (April or May), a decline into late summer, and then a strong rally into the end of the year. That is exactly what happened in 2011 and it has happened consistently over the last six election cycles. So the probability is fairly high that we can expect some downside in the months ahead.
How much downside do I expect? Back in January, when I gave my yearly stock market forecast, I argued that sometime in the second or third quarter we could expect a decline of greater than 10% in the averages. There has never been two years in a row, for example, when the S&P 500 Index did not at least re-test its 200 day moving average. I remain fairly confident that will happen in the months ahead.
What will trigger this pull-back is anyone’s guess. Will investors lose confidence in the Fed’s ability to engineer a soft landing? I could envision a scenario where bond holders, in a temporary state of panic, dump bonds and the resulting spike in interest rates spooks equity markets. Or it could be an event overseas in China, the Crimea or Japan that precipitates a waterfall-type sell-off. The point is that the “sell in May” (or April) phenomena may carry more weight this year than usual.
Readers should be aware, however, that such a decline, if it happens, does not usher in the end of the bull market or the beginning of a financial meltdown or anything other than a long overdue correction that will set the stock market up for further gains in the years to come.
All the macroeconomic data indicate to me that the economy will continue to grow and that growth is going to accelerate. The unemployment rate will also drop and probably faster than we expect. Interest rates in that kind of environment will also rise, so you bond holders out there better re-think your investments. So why in heaven’s name should the stock market swoon?
What many investors fail to realize is that the economy and the financial markets are not identical. The markets, unlike economic statistics, tend to encompass everything that occurs in the past, present and future. It is a reflection of our greatest hopes and fears. It usually discounts events six to nine months in the future and mid-term elections are eight months away. So what do you do?
It depends on your time horizon. If you are a long-term investor you might want to do nothing, weather the storm, accept paper losses and by the end of the year be whole again. If that is your decision, don’t panic and sell at the bottom like most supposedly long-term investors do. If you don’t cotton to living through that kind of decline, you might want to begin taking profits in some of your most aggressive holdings in the weeks ahead. Not now, but soon. I will keep you informed.