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:
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:
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:
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:
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.
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