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Stay The Course: Mid-Term Election Volatility Expected

|Includes: EWZ, Vanguard Value ETF (VTV), VUG
Summary

We highlighted the potential for volatility in October and still believe markets are set up for a rally following mid-term elections.

Current volatility and dynamics related to Federal Reserve raising rates resembles 1994.

Investors should stay the course.

Recent market volatility, while not unexpected, has rocked global financial markets over the last two trading days. We believe the decline in equity markets is simply following historical trends from prior mid-term election years. While often difficult during moments of high volatility in equity markets, we believe investors should stay the course as we anticipate a year-end rally following the November mid-term elections. Noted in our prior blog, “Don’t Get Spooked by October Volatility” (Link) the next three quarters have historically generated the highest returns during a four-year Presidential cycle.

The recent declines in equity markets have been substantial, wiping out most gains achieved during the third quarter of 2018. We believe three key factors are currently at play causing what we believe will be a temporary market correction. First, we believe historical volatility during mid-term election years has likely been pushed out from September into October. Second, the lack of company stock buybacks, which now equals a meaningful portion of daily trading volumes, has been removed while companies are in their third-quarter reporting quiet periods. Third, we believe the market is transitioning towards a more normalized market, meaning higher levels of volatility than what investors have become accustomed to over the last few years. We anticipate that each of these issues will be transitory in nature and will not lead to a protracted decline through year-end.

Earlier this year, during late January and early February, the market experienced its first volatility spike in several quarters. Different this time, stocks are moving lower into earning reports and not gaining significant momentum as was the case earlier this year. Thus, we anticipate that overall investor expectations for third quarter and fourth quarter guidance are much lower than they were just three to four weeks prior with markets near all-time highs. One similarity between today and declines earlier in the year, which may offer investors some encouragement, is that the cash or “spot” market for the Chicago Volatility Index (VIX) was higher than contracts for all future months. Simply put, investors have made bets on a short-term spike in volatility but aren’t placing significant bets that this volatility remains in place over the coming months. Looking at the chart below from the “McClellan Oscillator Report”(1) one can see that when this event has occurred in the last three years, it typically created a meaningful near-term downturn, but eventually saw markets surpass and regain levels from where the decline began. We believe that this trend is still in place and investors should expect a move back towards all-time highs following the mid-term elections.

Source: McClellan Oscillator Report

To a lesser extent, with roughly 74% of fund managers underperforming their benchmarks year-to-date, per CNBC, the need to buy into year-end for performance gains could be an additional catalyst for markets to recover from recent declines. However, while we expect markets to regain their footing over the coming weeks, we believe investors should be looking to diversify away from technology stocks which have worked well over the last ten years, towards more value-oriented companies. The outperformance of growth vs. value, shown in the chart below (Ticker:VTV vs. Ticker:VUG), has been significant in recent years. As interest rates rise, liquidity diminishes, and year-over-year growth slows from current levels, we believe value-based investments may finally see a return to favor. At Grinder Capital, we began a transition towards more value-based names earlier this year and have paid a price in performance relative to the continued outperformance of growth. However, historical trends tell us there typically is a reversion towards the mean, suggesting the potential for value investments to begin outperforming growth over the coming years.

Along with transitioning towards more value-based investments, we also continue to recommend investors look for global opportunities given the significant declines in markets, excluding the U.S. While rising interest rates could impact emerging market economies over the next few quarters, we believe that the valuation of non-U.S. listed stocks offers a significant discount to the current valuation of U.S. based markets. We would note the recent recovery in the Brazilian Bovespa, Brazil’s leading equity index, which saw declines early this year due to political concerns. However, the performance of EWZ, an ETF tracking Brazilian-based stocks, has risen from levels of ~$30 a month ago towards the ~$37-38 level today, equaling significant outperformance relative to U.S. markets over the same period. We believe opportunities globally may be more favorable in coming years than those offered by the U.S. and thus suggest investors look to diverse a portion of their holdings into non-U.S. investments.

The recent pain experienced by global equity investors has not been pleasant the last few days. We believe the recent correction was necessary to build a base from which equity markets can rally through year-end and potentially into the New Year. This is similar to the historical patterns in prior mid-term election years, albeit perhaps a 1-month lag. Concerns over interest rates have previously spooked markets, with January/February 2018 being the most recent event. We expect the market will adjust to higher rates, which are still significantly low compared with historical levels, but will likely experience more normalized levels of volatility than trends seen in recent years. We don’t see the recent declines in equity markets as the beginning of the end and expect further market appreciation over the next 6-9 months.

Finally, we include below the chart of the S&P 500 in 1994, a mid-term election year, which demonstrated significant declines in October only to rally to new highs by year-end. The author of the chart, Tom McClellan(2), sees similarities with today’s markets. “In the election of 1992 there was an insurgent candidate, who did not win a majority of the popular vote, but who took the White House and set about reorganizing the government in a manner more to his liking. The first two years of his term in office were marked by numerous scandals, and by a stock market which saw a scary dip in the 2nd year which eventually resolved itself into a strong uptrend during the 3rd year of his presidential term. At that time, the Federal Reserve was commencing a program of rate hikes, which had market participants worried.” We believe patterns tend to repeat over time, thus hope remains for further upside in the coming months.

Source: McClellan Oscillator Report

Sources:

  1. McClelland, Tom, “Here is a chart from my Daily Edition tonight”, McClellan Financial Reports, October 10, 2018, Tom McClellan on Twitter

  1. McClelland, Tom, “Deja Voodoo, 1994 Edition”, McClellan Financial Reports, August 30, 2018, Deja Voodoo, 1994 Edition - Free Weekly Technical Analysis Chart - McClellan Financial