An Overbought Market In An Election Year: What You Need To Know

| About: SPDR S&P (SPY)

Summary

The market has been overbought for a month and a half now.

This election year, we are looking at a high probability of a bear market.

The next bubble will burst once investors stop accepting central bank stimulus as more important than actual company fundamentals.

The market has been overbought for a month and a half now:

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And this applies to virtually every industry within the market. The natural question is how much longer must we wait until the next correction? Some investors are saying, "This time is different," implying that we will continue this rally to new heights.

I disagree because this year really is different: It's an election year.

The Stock Market and Election Years: Predicting the Next President

The stock market has correctly predicted 19 of the last 22 presidents. Market historian James Slack pointed this out in his analysis of the stock market leading up to presidential elections. In the three months prior to the election, the incumbent party would hold office when the market was up; they lost when the market was down:

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The accuracy of this prediction is 86.4%. As one of my university math professors used to say, "That's a probability you can bet your life on."

The powers in charge also understand the importance of the stock market leading up to the election. The incumbent party would certainly benefit from bolstering the stock market into the election. The question is whether they have any power to do so.

The members of the Federal Reserve arguably have more power than members of the government. Ex-FOMC chairman Martin once refused President Truman's demand to keep interest rates down. Indeed, the FOMC is sovereign in its decision making, holding the power to make or break the market through sudden rate changes.

Still, FOMC members are people. And people have agendas. In contrast to the many hawkish statements of the other FOMC members, current chairman's Yellen statements remain dovish.

Investors should note that Yellen is the first Democratic nominee of the Fed, and logically one does not acquire such a position without expectations. It is becoming increasingly obvious that raising interest rates is a necessary policy for fixing the US economy, but Yellen has thus far fought for holding interest rates at their current level, possibly because of the effect of the December rate raise: The 25bp raise in December was virtually meaningless in terms of a raise, yet it rippled through the stock market, causing a 10% correction.

Whether Chairman Yellen has the side-agenda of keeping the Democrats in power can have a significant impact on how long this current rally is sustained.

What Analysts Are Saying

Deutsche Bank (NYSE:DB) recently predicted the S&P 500 to be range-bound between 1925 to 2100 until after the election. Putting this in the current context shows the following:

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That is, our resistance level is below the all-time high but the support level is above the recent January-February market correction. If we see an oscillation between these two levels, we will likely see a change in direction every 2 months, giving us an upward movement into November (which would imply a Democratic victory). Still, this is under the assumption that DB is correct.

DB states that a "double dip" has already occurred and thus should not occur again unless clear signs of a recession make themselves available to investors. I disagree with such arbitrary technical analysis (What makes a "double-dip" indicative of a bull market?). And I believe that the signs of a recession are already in; it's just that investors aren't looking at the data (It's actually more than that - permabull media are overreporting good news and hiding bad news):

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DB also points to April and May being strong months for the market yet also state that EPS is down y/y, contradicting their previous point that signs of a recession are not in. In addition, DB mentions the Fed as likely to become more hawkish as a result of many aspects, including the recent rally, the coming presidential election, a continued bear market for commodities, and the weakening of a dollar. A hawkish Fed generally leads to a downtrend in the market, which is contradictory to the idea that the S&P will stay 100 points above the support of the last market correction.

These reasons impress me as much as DB's past performance of predicting the market. Instead, I suggest we turn to statistical patterns in election years to get a better idea of election year sentiment.

January Sets the Tone for the Year

Before we dig into the patterns of presidential years, we should note that the first five days of January has over an 85% accuracy rating for predicting whether the year will be bullish or bearish. This year, the first five days of January brought us a drop of nearly -6%, predicting a bearish year.

Using the month of January is even more accurate. Every down January since 1950 has been followed by a bear market. This January was down 7% as a whole, strengthening the bearish prediction for the year.

Another nearly perfect indicator for a bearish year is whether we cross below the December low in Q1. Last year's December low was 1993.26, and we certainly broke this in early January. Overall, the results of January and Q1 2016 are giving ominous signs of a coming bear market.

Election Year Trends

This election year, we are looking at a high probability of a bear market. Election years typically underperform pre-election years by half, and this trend has been strengthened over time (i.e., election years have given way to increasingly weaker gains). Election years for presidents who have sat for two terms are particularly bad.

The average decline in the S&P 500 for the 8 th year of a presidential term is -11%. Considering that we are up year-to-date, this implies a significant fall should the trend hold. Only one 8 th presidential year has ended in the positive.

By my estimates, a bear market that begins in 2016 should take the S&P 500 to around 1,500.

In presidential years, the incumbent party hopes to stay in power. As the state of the stock market is one metric by which a party's effectiveness is judged, the party has much reason to manipulate the markets, directly or indirectly, to keep the stock market afloat. We have seen such actions through the bailouts after the last financial crisis and the Fed's not-so-concealed method of pumping money into stocks, which are already overbought.

Government spending and an increasing deficit are fiscal policies that indirectly increase disposable income, much of which is funneled into the stock market. Dovish remarks from the fed despite the clear need for higher interest rates also push stocks upward. And the recent implication from the Fed that the planned four rate hikes will be cut to two rate hikes certainly help the market.

Fundamentals

Seeking Alpha is a site primarily for fundamental investors. The sad fact of today's market, however, is that the fundamentals matter increasingly little. Despite several fundamental warnings that stocks are overpriced, the market continues upward.

GDP growth is particularly worrisome. Every year, optimistic predictions are made. Yet every year, GDP growth continues to fall, dragging the economic forecasts with them:

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Stock prices should rise when earnings rise. Recent earnings reports have shown rising EPS but falling revenue:

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(Source: Valuewalk)

This is a concerning trend: It's easy to manipulate EPS by reducing outstanding shares - simply engage in record numbers of buybacks:

It's much harder to manipulate revenue. Still, earnings overall show a downward trend in spite of the upward market trend:

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Clearly, the fundamentals are less reliable at the present moment. Seasonal factors, such as the election, and intervention on part of FOMC seem to be more important players than earnings and revenue, so much so that some traders are beginning to outright ignore fundamentals.

Food for thought: Bubbles pop once fundamentals come back into play. The dot com bubble burst once investors stopped accepting three-digit PE ratios for stocks with no profits; the real estate credit bubble burst once investors stopped accepting the purported safety of mortgage-backed derivatives.

The next bubble will burst once investors stop accepting central bank stimulus as more important than actual company fundamentals.

Conclusion: Now Is the Time to Hedge

March has performed well, statistically, during election years. We can describe the recent rally as central bank intervention fueling short covering - completely unrelated to the market. But April is typically when the fundamentals come back in line with price movement.

With earnings season ahead and the fact that earnings have been on the decline, this could be the month when the bear market begins. Also notable is the fact that stock prices tend to move prior to earnings, in expectations of surprises. (We talk about this and use drift as an indicator in our Exposing Earnings Newsletter.)

Investors who have benefitted from both the recent short-covering rally and the 7-year bull market should lock in their gains by hedging against a bear market. The best way to play this election year is by exercising caution. Here are three strategies that should prove useful moving into April:

Add some inverse ETFs to your portfolio. I like the Proshares Ultrashort S&P 500 ETF (NYSEARCA:SDS), the Proshares Ultrashort QQQ ETF (NYSEARCA:QID), and the Direxion Daily Emerging Market Bear 3X ETF (NYSEARCA:EDZ).

Invest in volatility. Consider playing straddles on the SPDR S&P 500 ETF (NYSEARCA:SPY) or simply buy the S&P 500 VIX ETN (NYSEARCA:VXX).

Buy married puts on your holdings to limit losses.

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Disclosure: I am/we are long VXX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.