How To Monitor The Risk Of A Midterm-Election-Year Stock Correction

Summary

• History tells us that midterm election years often are marked by a stock market peak in the spring, followed by a new yearly low in the fall.
• If you are not sleeping well due to fears of a midterm correction in 2014, there are logical ways to keep your fears in check while managing portfolio risk.
• A simple risk monitoring system is illustrated using midterm-election-year corrections that occurred in 1982, 1990, 1998, and 2010.
• Since fundamentals will determine the market’s 2014 fate, we revisit the problems of the day in 1982, 1990, 1998, and 2010, noting Russia as a ongoing wild card in 2014.

The Other Side Of The Midterm Coin

In an April 1 article, we cited two midterm election years, 1986 and 1994, as cases where assuming stocks would follow the accepted midterm correction script proved costly. Today, we will look at midterm election years that experienced a mid-year correction and answer the question:

How can we monitor the risk of the midterm-election-year correction pattern in stocks playing out in 2014?

After understanding the "look" of a midterm correction and the fundamentals associated with each historical episode, we will compare those corrective periods to the present day. For those not familiar with the midterm correction theory, the text below provides a good summary:

Midterm election years are typically poor performers for most of the year until finding a bottom in the fall and beginning a rally which lasts well into the following pre-election year. The traditional approach to seasonality during a midterm election year shows the final high (prior to the long period of under-performance) in April.

The Same Concepts We Used In 1987 Example

Regular readers know our approach to the markets basically involves paying attention and making allocation adjustments, rather than allocating our investment capital based on predictions or forecasts. Since we have covered the concepts used in today's article in the past, we will hit the high points below. If you are looking for more detail on how to assess investment probabilities using the charts below, see this video segment from 1987: If It Happens Again, Will You Be Ready?

1982: Falklands War

To monitor the risk of a midterm-election-year correction in stocks, you do not need to know much of anything about reading or using stock charts. A simple visual inspection can go a long way on the risk management front. The 1982-1983 chart below shows the S&P 500 in black/red and various moving averages in blue, red, and green. The risks of a stock market correction increase from a probability perspective when (a) price drops below all the moving averages, and (b) the slopes of all the moving averages roll over in a bearish manner. Conversely, the odds of good things happening in the stock market begin to improve when price moves back above the moving averages, and the slopes of the moving averages turn back up. The chart below sent up warning flares in May 1982. The stock market bottomed in August, which was soon followed by an improvement in the evidence on the chart.

As we noted on April 1, if a midterm correction is coming in 2014, it will be based on the fundamentals in 2014, rather than any magical link to midterm years, such as 1982, 1986, 1990, 1994, 1998, or 2010. Were there fundamental problems in 1982? Yes, a brief refresher list is provided below:

1. Unemployment in the U.K. increased by 129,918 to 3,070,621, a post-war record number.
2. Hama massacre took place in Syria.
3. The DeLorean Motor Company Car Factory in Belfast was put into receivership.
4. The U.S. placed an embargo on Libyan oil imports, alleging Libyan support for terrorist groups.
5. The Falklands War began: Argentina invaded and occupied the Falkland Islands.
6. A blizzard brought 1-2 feet of snow to the northeastern United States, closing schools and businesses, snarling traffic, and canceling several major league baseball games.
7. In the Falklands War, the nuclear submarine HMS Conqueror sank the Argentine cruiser General Belgrano, killing 323 sailors.
8. The 1982 Lebanon War began.
9. The United Nations Security Council passed a resolution demanding that Israel withdraw its troops from Lebanon.
10. Four Iranian diplomats were kidnapped after Israel's invasion of Lebanon.
11. The Provisional IRA detonated 2 bombs in central London, killing 8 soldiers and wounding 47 people.
12. Italian Prime Minister Giovanni Spadolini resigned.

1990: Gulf War

With fundamental concerns piling up, the observable evidence started to say "be careful with stocks" in late July 1990 (see chart below). Subsequently, the S&P 500 dropped sharply over the next ten weeks. As investors' perception of future economic outcomes began to improve, stocks found a bottom in October 1990. Stocks rallied sharply for five months after the observable evidence began to improve in November. The simple moving average system was helpful in terms of managing investment risk.

A sample of some of the issues that drove stock prices in 1990:

1. Soviet troops occupied Baku and killed over 130 and wounded over 700 protesters for national independence.
2. The government of Haiti declared a state of siege and suspended civil liberties.
3. Police sealed off Brixton in South London after another night of protests against the poll tax.
4. The longest prison riot in Britain's history began at Strangeways Prison in Manchester; it continued for 3 weeks.
5. Iraq invaded Kuwait, eventually leading to the Gulf War.
6. The United Nations Security Council ordered a global trade embargo against Iraq in response to its invasion of Kuwait.
7. President of Pakistan Ghulam Ishaq Khan dismissed Prime Minister of Pakistan Benazir Bhutto, accusing her of corruption and abuse of power.
8. U.S. President Bush ordered U.S. combat planes and troops to Saudi Arabia to protect against possible attack by Iraq.
9. Prime Minister of India V. P. Singh announced a plan to reserve 49% of civil service jobs for lower-caste Hindus. The plan triggered riots, leaving at least 70 dead by September.
10. Iraq announced it had formally annexed Kuwait.
11. Members of the Provisional Irish Republican Army killed Major Michael Dillon-Lee and Private William Robert Davies of the British Army.
12. Fighting broke out in Romania in the aftermath of the Romanian Revolution of 1989.
13. In Kenya, riots erupted against the Kenya African National Union's monopoly on power.
14. President of Bulgaria Petar Mladenov resigned over charges he ordered tanks to disperse anti-government protests in December 1989.
15. In South Africa, fighting broke out between the Xhosa people and the Zulu people; more than 500 people were killed by the end of August.
16. U.S. President Bush called up U.S. military reservists for service in the Persian Gulf Crisis.
17. President Bush delivered a nationally televised speech in which he threatened the use of force to remove Iraqi soldiers from Kuwait.

1998: Russian Financial Crisis & Long-Term Capital Management

Using evidence to manage risk can be extremely helpful when markets flip from risk-off to risk-on as they did in 1998. With fears escalating related to the Russian Financial Crisis and the collapse of Long-Term Capital Management (LTCM), Alan Greenspan decided he had seen enough. The Fed chairman pushed for an agreement that was eventually reached on September 23, 1998 among fourteen financial institutions for a $3.6 billion recapitalization (bailout) of LTCM under the supervision of the Federal Reserve. The use of moving averages were very helpful in 1998 and 1999 as shown below.

A sample of some of the issues that drove stock prices in 1998:

1. The United States Senate passed Resolution 71, urging U.S. President Bill Clinton to "take all necessary and appropriate actions to respond to the threat posed by Iraq's refusal to end its weapons of mass destruction programs".
2. The Oued Bouaicha massacre occurred in Algeria: 52 people were killed.
3. Pakistan tested medium-range missiles capable of hitting India.
4. India conducted 3 underground nuclear tests.
5. Riots directed against Chinese Indonesians broke out in Indonesia. Indonesian natives destroyed and burned Chinese Indonesian-owned properties and killed more than 1,000 Chinese Indonesians.
6. Pakistan tested nuclear devices.
7. The Second Congo War began; 3,900,000 people were killed before it ended in 2003.
8. The bombings of the United States embassies in Dar es Salaam, Tanzania, and Nairobi, Kenya took place. They killed 224 people and injured over 4,500; they were linked to terrorist Osama Bin Laden, an exile of Saudi Arabia.
9. Russian government and the Russian Central Bank devalued the ruble and defaulted on Russian debt.
10. The Omagh bombing was carried out in Northern Ireland by the Real IRA.
11. The Government of North Korea adopted a military dictatorship on its 50th anniversary.
12. The Cuban Five intelligence agents were arrested in Miami, and convicted of espionage.
13. U.S. President Bill Clinton ordered airstrikes on Iraq.

2010: Greece Downgrade & Flash Crash

If your system can help lessen the damage during the 2010 Flash Crash, then it can probably help in most circumstances. The Flash Crash scenario and the chart below are described in detail here. The concepts are easy to follow in the chart below from a visual and risk-management perspective.

A sample of some of the issues that drove stock prices in 2010:

1. The United States and the United Kingdom closed their embassies in Yemen due to the ongoing security threat by Al Qaeda.
2. Standard & Poor's downgraded Greece's sovereign credit rating to junk 4 days after the activation of a €45-billion EU-IMF bailout, which triggered a decline in stock markets worldwide, weakness in the euro, and deepened the European sovereign debt crisis.
3. The eurozone and the International Monetary Fund agreed to a €110 billion bailout package for Greece. The package involved sharp Greek austerity measures.
4. Protests took place in Bangkok, Thailand and ended with a bloody military crackdown, which killed 91 and injured more than 2,100.
5. Eurozone countries agreed to a rescue package for the Republic of Ireland from the European Financial Stability Facility in response to the country's financial crisis.
6. North Korea shelled Yeonpyeong Island, prompting a military response by South Korea.
7. The European Union agreed to an €85 billion rescue deal for Ireland from the European Financial Stability Facility, the International Monetary Fund and bilateral loans from the United Kingdom, Denmark and Sweden.

How Does The Same Chart Look Now?

The answer is "not bad, not bad at all". The version of the chart below is as of 10:36 a.m. EDT Wednesday. Notice price is above all the moving averages and the slopes of the moving averages are all positive, telling us the battle between bullish and bearish economic conviction is being won by the bulls in April 2014.

Could Russia Kick-Off 2014's Crisis?

Since many of the midterm election years covered above also had a fundamental or geopolitical crisis, it is logical to keep an eye on the tension between Russia and Ukraine. From Bloomberg:

NATO leaders warned today that Russian forces massed near the country's border with Ukraine are in a high state of readiness and that any incursion across the frontier would be a "historic mistake." The presence of as many as 40,000 soldiers along Ukraine's eastern border is fueling concern that Russia is poised to invade on the pretext of protecting Russian-speaking inhabitants of eastern and southern Ukraine.

Investment Implications - Still Long

Is the simple risk management system shown above perfect? No; our market model uses numerous methods to monitor risk, which provides a form of method diversification. The current read of the technicals and fundamentals continues to favor growth assets, such as stocks, over conservative assets, such as bonds. Therefore, we continue to hold positions in the S&P 500 (SPY), technology stocks (QQQ), and an equally-weighted S&P 500 ETF (RSP). Our model called for a reduction in cash and an increase in equity exposure Tuesday. While the evidence has improved, we still must respect the concerns tied to Russia and slowing bullish conviction, as outlined on March 20.

Pay Attention To 2014's Fundamental Developments

It may be fair to say that the midterm-election-year pattern calling for a correction in stocks has very little to do with midterm elections, given the bearish events that occurred in 1982, 1990, 1998, and 2010. It is also fair to say that the odds of a market correction will be higher in any year that contains an event similar to the Falklands War, Gulf War, Russian Debt Default, collapse of LTCM, or the European Debt Crisis. Similar to 1982, 1990, 1998, and 2010, the markets in 2014 will be driven primarily by the economic and geopolitical events of the day, rather than a historical election year or chart pattern.

Disclosure: I am long SPY, QQQ, RSP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.