The shape of the market to come—similar but different

Welcome to this week’s addition to our Politics and the Financial Markets series. Every week through the week after Election Day, we will explore the historical relationships between politics and the financial markets. Then there will be a bonus article after the election reflecting the Political Seasonality Index (PSI) projections once we know the winners. Our Politics and the Financial Markets series will be presented with our regular market commentary in our weekly Market Hotline Newsletter. To catch up on the other articles in this series, go to our Politics and the Financial Markets webpage.

We’ve seen in past articles in this series that markets are affected differently depending on which party controls Congress, the presidency, and the Federal Reserve. While party control is important, the question of incumbency and the year in the presidential cycle (more on this next week) also have an impact.

This week I’m going to pull all of these Election Day issues together (four in all) to see what this leftover Halloween witches’ brew projects for the rest of this year and all of next year. As I reported last quarter, this combination has been especially well-correlated with this year’s daily market action (over 90%).

The data, which stretches back to 1885, is drawn from just a portion of the 13 indicators that are included in our Political Seasonality Index. The yardstick we are measuring against and predicting is the price-only value of the Dow Jones Industrial Average.

The results are shown in the four sets of graphs that follow. The constant in all of the charts is that they use data during the first year of the four-year presidential election cycle and only when there is a non-incumbent election. Each set reflects one of the four combinations of presidential party, Senate party, and House party.

There are actually eight combinations possible, but I have only included the four that seem likely at the moment. (If you’d like to see the four I’ve omitted, just email me.) There is only one Republican presidential chart as it seems likely that if Mr. Trump wins, the House and Senate will stay in Republican hands.

Here are the possibilities we will examine:

RRR: Republican president, Senate, and House

DRR: Democratic president, Republican Senate, and Republican House

DDR: Democratic president, Democratic Senate, and Republican House

DDD: Democratic president, Senate, and House

At first glance, the charts look very similar. Since the market tended to go up over most of the last century, all of the charts slant upward, indicating higher prices. This is always the case with any PSI chart and is the reason that, for trading purposes (and our PSI strategy), we only use the chart to determine market turning points. To determine these more easily, I’ve included both a chart of the period from Election Day until the end of this year and one until the end of next year.

For the purposes of this article, where we are trying to gauge the relative performance of the different combinations, the levels reached in the charts are revealing, too. For example, the charts that show data for only 2016 reveal that the worst post–Election Day combination, due to a bad start immediately after Election Day, is DDD. The best combination is DRR, followed closely by RRR.

Looking at the longer-term chart through the end of next year, DRR and RRR once again gain the most ground, while DDR trails substantially and demonstrates the most volatility.

Next week, I’ll look at the four-year election cycle based on presidential cycle and discuss what sectors have benefited most by the party in the White House during each year. And in the week after the election, we will provide a projection of what 2017 will look like using all of the factors of the Political Seasonality Index once the winners are known.

Market Notes – “Unprecedented”

As the chart of Friday’s intraday action in the S&P 500’s SPY ETF demonstrates, the stock market continues to be dominated by the election. As you can see, stocks plunged on Friday afternoon’s news that the FBI was taking another look at emails that could be connected to the Hillary Clinton personal email server case.

The stock market has been a Clinton market for most of the summer, with its prospects rising and falling in line with the Democratic candidate. In my opinion, this has been primarily the result of her lead in the polls and almost insurmountable advantage in the Electoral College. The near certainty of her election has helped alleviate the uncertainty normally associated with a national election. And as we know, uncertainty causes volatility that almost always is to the downside.

Friday’s October surprise, one of a series this year (with no doubt more to come of the November variety), was not unprecedented. Back in 1992, when George Bush Sr. and Mr. Clinton were fighting down to the wire, news came three days before the election that the Iran-Contra Independent Counsel had indicted President Reagan’s defense secretary, Caspar Weinberger, at the same time calling into question Bush’s statement that he had not been “in the loop” during his service as VP in the previous administration. Bush went on to lose the election, even though a month after the election that indictment was thrown out by the federal courts. Of course, by then Bill Clinton was president-elect. (President Bush did pardon Weinberger for an earlier indictment as he left office, ending the matter. Perhaps a similar result will occur here.)

With such precedent, the market and Secretary Clinton supporters are justifiably worried that even with the extra week of damage-control opportunities this time around, the near certainty of her victory may not be as certain. This increase in uncertainty has sent stock prices moderately lower ever since the latest announcement.

The decline in prices has sent stocks back down to, and marginally through, support levels. This could set off a modest decline of its own. As I have been reporting, the market has been stuck in an area where a break to the upside or downside appears imminent.

Economic reports improved a bit last week for the first time in months. Better-than-expected reports outnumbered those failing to beat economist expectations.

Earnings reports continue to outperform, as well. With more than half of the S&P 500 companies reporting, 67% of reporting companies topped analyst projections.

Finally, among the positive indicators, investor sentiment continued to be bearish. Over 75% of investors are not bullish, according to the AAII Sentiment Survey. This is a contrary indicator.

The number one negative has been the increase in interest rates. Whether or not the Federal Reserve raises its interbank lending rates, the bond market has already spoken.

Rates have broken out to new short-term heights. This comes at the same time as, and perhaps as a result of, new heights being recorded in the dollar, a jump in wage costs, inflation rates, and a decline in inventories. The only offset seemed to be a renewed decline in energy prices.

While our short-term timing indicators have been pointing lower, intermediate-term (one to three months) strategy indicators have continued fully invested. Unless you are into short-term timing (the risk of which is that you give up unexpected gains later even if you are right at first and the market declines), it would appear that the best approach continues to be to stay the course.

Regardless of your political persuasion, I think you would agree that this election year is “unprecedented,” at least in our lifetimes … and there is one more week to go.

All the best,

Jerry