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Another Cycle To Consider

Daily State of the Markets
Thursday, September 20, 2012

Good morning. Although the bears will contend that stocks are overbought, that sentiment is too upbeat, and that the market is a single headline away from launching into a significant downtrend, so far at least, it appears that the major indices are merely consolidating the recent QE-induced gains during this quadruple-witch options expiration week. And since the intraday volatility hasn't been too intense this week, I've had a little time on my hands to review some bigger picture indicators and themes.

If you will recall, on Monday I talked about the idea that trading on one's global macro view can lead to a "need to be right," which has caused a great deal of underperformance so far this year. On Tuesday, we took a peek at the "breadth thrust buy signal," which, in addition to being one of our favorite market indicators, tells us that the odds favor the bulls in the coming months. And then yesterday, we perused the history of the "cycle composite" (a combination of the one-year seasonal cycle, the Presidential cycle, and the 10-year market cycles), which suggested that a pullback over the next month or so would be in keeping with the historical trends.

This morning, I thought I'd dive a bit further into the cycle work to see if the Presidential election cycle has anything meaningful to offer. In our research, we took a look at how the market acted in all the elections since 1900, in the cases where the incumbent party won the election, and when the incumbent party loses. We also reviewed the outcomes of elections relative to the performance of the stock market prior to the election and compared all of the above to the current election cycle.

In looking at the traditional Presidential election cycle, the good news is that the Dow Jones Industrial Average tends to produce solid gains during election years. The typical cycle sees stocks go sideways in the first quarter of the year, rally into May, correct into July, rebound strongly into September, pull back a bit into early October, and then enjoy the usual year-end rally.

However, when the incumbent party loses the election, the early rally tends to fizzle quickly, the summer soon is more pronounced, the decline in September/early-October tends to last longer and be much more severe, and the typical year-end rally never really gets going, leaving the DJIA lower on the year.

In looking more closely at the September/October period of each cycle, it becomes clear that the stock market tends to favor an outcome that doesn't change things politically. While the Presidential cycle does sport a pullback during September regardless of which party wins, when the incumbents win the pullback tends to be much shorter and far less intense than when the incumbent loses. In fact, history shows that if the incumbent party winds up retaining the White House, the September declines end before the end of the month and then give way to a meaningful rally which lasts into early December.

There is one additional bit of historical data that is worth considering before one places their bets on the outcome of the election. Remember that the stock market hates uncertainty and tends to discount the future. As such, when the DJIA has sported gains of more than +8.5% through the end of August, the bottom line is the incumbent party tends to win the election. In fact, since 1900 the fine folks at Ned Davis Research tell us that when the DJIA has sported a gain of +8.6% or more through late August, the incumbent has lost on only three occasions.

With the DJIA currently up more than +11% YTD (the S&P is up +16.2%, Smallcaps are up +16.0%, Midcaps sport a gain of +15.2%, and the NASDAQ has gained an impressive +22.2% - thanks in no small part to AAPL), the stock market would appear to be casting its vote early - at least from an historical perspective.

So let's review. The "breadth thrust buy signal" from last Friday tells us that stocks have rallied nicely in months following the signal. Then the "cycle composite" suggests that it's time for the market to pull back. And finally, the Presidential cycle suggests that the severity of the sloppiness typically seen in September will depend on who wins the election. If the Democrats can retain the White House, any pullback should be short and shallow. But if the Republicans can emerge victorious, stocks may actually suffer into the election.

While all of this is interesting and can certainly serve as a nice backdrop when making investment decisions, remember that we prefer to rely on our active risk management systems to guide our exposure. But the Presidential cycle is clearly a cycle worthy of consideration.

Turning to this morning... Weak Flash PMI data out of Europe and China has produced a sea of red numbers in the overnight markets and is pressuring the futures in the U.S.

On the Economic front... We'll get reports on Weekly Jobless Claims, the Flash PMI, Philly Fed and the LEI this morning.

Thought for the day... Let him that would move the world first move himself. -Socrates

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

  • Major Foreign Markets:
    • Australia: -0.79%
    • Shanghai: -2.07%
    • Hong Kong: -1.20%
    • Japan: -1.57%
    • France: -0.65%
    • Germany: -0.42%
    • Italy: -1.49%
    • Spain: -1.02%
    • London: -0.62%
  • Crude Oil Futures: -$0.74 to $94.55
  • Gold: +$2.50 to $1773.70
  • Dollar: higher against the yen, euro, and pound
  • 10-Year Bond Yield: Currently trading at 1.783%
  • Stock Futures Ahead of Open in U.S. (relative to fair value):
    • S&P 500: -5.80
    • Dow Jones Industrial Average: -40
    • NASDAQ Composite: -9.83

Positions in stocks mentioned: AAPL

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