This post was originally published on this site
Odds are good that the U.S. stock market will rally strongly after this November’s mid-term election. That’s the good news. But we have to pay a price first: In order for that rally to occur, the market must be weaker than average as Election Day approaches.
The market’s rally potential exists because of the overlap of two powerful seasonal patterns on Wall Street. The first is the so-called Presidential Election Year Cycle, which holds — among other things — that the stock market typically produces its best returns in the third year of the cycle. If, like most researchers, we count presidential terms in fiscal-year terms ending Sep. 30, then the cycle turns positive for stocks this coming October 1.
The second seasonal pattern is the so-called Halloween Indicator, otherwise known as “Sell in May and Go Away.” It holds that the stock market tends to produce above-average returns between Halloween and May Day (the so-called “winter” months) and mediocre returns during the remaining “summer” months. As I’ve reported before, researchers have found that this seasonal pattern traces almost exclusively to the winter periods of presidential third years — which in the current cycle begins this coming Nov. 1.
Putting these patterns together, we should expect a significant low this coming fall for major U.S. markets such as the S&P 500 SPX, -0.13% and the Dow Jones Industrial Average DJIA, -0.62% . The accompanying chart summarizes the strength of these overlapping seasonal patterns; the contrast between third-year winters and other six-month periods is significant at the 95% confidence level that statisticians often use to determine if a pattern is real.
To be sure, you should never bet on a statistical pattern unless there also is a plausible theory that explains why it should exist in the first place. In this case, at least, such a theory appears to exist.
We owe the discovery of this theory to Kam Fong Chan, a senior lecturer in finance at the University of Queensland in Australia, and Terry Marsh, an emeritus finance professor at the University of California, Berkeley, and CEO of Quantal International, a risk-management firm for institutional investors.
In an interview, Marsh said that he and his fellow researcher, in a soon-to-be-published study, report strong evidence that the mid-term elections are the major culprit in the stock market’s low that is registered in the fall of mid-term election years. That low can be traced to the considerable uncertainty created by the mid-term elections, which have the potential for shifting control of either the House or Senate, or both. Once the election is over and that uncertainty is removed, the market typically recovers.
Already this year, it is worth noting, the uncertainty surrounding the mid-term elections has been front-page headlines. For example, the special congressional election in Pennsylvania on March 13 has been billed as a referendum on President Trump’s presidency and a harbinger of whether Congressional control will shift from Republicans to Democrats.
The bottom line? Market dynamics over the next 12- to 18 months are a no-pain, no-gain situation. The pain comes in the form of market weakness the midterm elections approach, to be followed by a strong rally. Without the first we don’t get the second.
Note carefully that the six-month rally that I’m referring to is not inconsistent with the long-term bearishness that is the conclusion of various valuation indicators. Even multi-year — secular — bear markets experience powerful counter-trend rallies.