Research & Advice

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Shallow Mid-Term Year Correction

Friday, August 22, 2014

 

  • Mid-term elections are less than three months away. With control of the Senate up for grabs and plenty of would-be presidential challengers positioning for a run in 2016, political rancor will surely dominate the media as the first Tuesday in November approaches.
  • The late July / early August 4.5% pullback pushed short-term sentiment gauges into a healthy pessimistic zone (a contrary indicator), without damaging market internals, so we have become more encouraged about equity allocations.
  • But now that a correction is behind us, we need to address the concern that mid-term elections typically see very large corrections.   The correction is either late (on average, a mid-term correction starts in mid-April), or very shallow. It appears to have been merely shallow.

Historically, the stock market has tended to follow a four-year pattern, defined by election cycles. And while the yearly charts don’t exactly repeat, they have – mostly –rhymed. In the context of 2014 the most important word in the previous sentence is “tended” because the typical mid-term correction has not come to fruition – at least not yet. As has been the case for much of the year, elevated investor optimism suggest risks remain elevated and the stock market remains vulnerable to shocks. But the late July / early August 4.5% pullback pushed short-term sentiment gauges into a healthy pessimistic zone (a contrary indicator), without damaging market internals, so we have become more encouraged about equity allocations.

But now that a correction is behind us, we need to address the concern that mid-term elections typically see very large corrections. As mentioned previously, historically the stock market follows certain cycles on a calendar year basis. Comparing the actual price movement of stocks in 2014 to the expected returns, there are four observations:

1)      The correction is either late….On average, a mid-term correction starts in mid-April. The Dow Jones Industrial Average’s (DJIA) latest high was on July 16. The four-year pattern bottoms in late September, and the one-year pattern bottoms in late October, so it would be premature to declare that seasonal risks have passed.

2)      …or the correction was historically shallow. Even if you include the February 7.3% correction, that was still the fifth-smallest drop for mid-term years through Election Day since 1902. The most recent 4.5% correction would put it closer to the actual election date, and be the second-smallest.

3)      And is followed by a year-end rally…mid-term corrections have left the market oversold. From the mid-term low, the DJIA has rallied a median of 18% by year-end. Even when the mid-term corrections have been less than 10%, the year-end rally has been 14%, on average.

4)      …that carried into Year 3. Year 3 of the four-year presidential cycle (2015) is the strongest of the four years, with a median gain of 14%. Even with the smaller corrections in the mid-term year, leaving the market less oversold, the market has still managed double digit gains in Year 3, on average.

Also, we must consider the potential of a Fed tightening cycle in Year 3. Part of the reason that mid-term years have been weak has been that the government has been restrictive during the first three quarters of the mid-term year before accelerating through Year 3.

Fiscal policy should turn positive as the year-over-year effects of the sequestration comes off the books. Monetary policy remains the wild card. The Fed is on track to end quantitative easing by October and begin to raise short-term interest rates six-months later, according to Federal Reserve Chair Yellen’s comments.

Tighter monetary policy has not dampened the Year 3 rally, based on the seven previous cases in which the Fed began tightening cycles during the mid-term year, or Year 3. Mid-term corrections in those years that have experience tightening cycles have typically been larger than average, but the responding rally has been modestly smaller.

The bottom line: For Year 3 of the 4-year presidential cycle is that neither shallow mid-term corrections nor the beginning of tightening cycles have significantly diminished the bullish seasonal period from the end of the mid-term year through the end of Year 3, on average.