Wednesday, January 22, 2014

Mid-term Election Years and Stock Market Performance – What can be Learned?

Many prominent investing managers and firms are warning of a likely 10% stock market pull-back in 2014, so I figured it might make sense to assess what might cause the market to break-down.

You might be expecting my rationale for a potential 2014 pull-back in stocks to start with continued poor corporate revenue growth and low aggregate demand relative to the acceleration in share prices in 2013. Such an analysis, although relevant, would be far too rational an approach for the current political economy in my opinion.  Fundamentals have rarely mattered since the 2008 crisis, and I do not expect a change in the Federal Reserve driven 2014 economy. The current stock market is pricing in slow but steady growth and a Federal Reserve that continues to remain a backstop for any downturn.  Who can lose in this environment?

But factors exist that potentially are not priced into the market.  And one that I find very intriguing is the potential change on the horizon that could be triggered by the upcoming mid-term election.

Mid-term election years tend to be turbulent for the stock market, possibly due to uncertainty surrounding government policy post election. Thanks to the primary data in the above chart compiled by Robert Schiller of Piper Jaffrey, you can see the historic volatility in mid-term election years, with peak to trough declines in the market in the 21 years analyzed showing a median pull-back of over 17%.  What the data did not show was the market momentum in the year prior to the mid-term elections, and the results for the full mid-term election year.  This data has been overlaid in color for the 18 mid-term elections since WWII.

The years in the graph which are circled in red or yellow are time periods associated with market corrections that entailed full year over year market declines, and generally were also associated with a recession. The year 2002 is a good example of a year in which the stock market was declining entering the year, and continued declining through the entire year.  Whereas in 1982 the market entered the year in decline, and the economy was in recession, but the market improved through the year and ended higher.

In the years showing only a green circle, such as 1998, the stock market from January through December ended in positive territory, and the economy did not exhibit a recession.

What is interesting about the aggregate data is that if the stock market began the year going into the mid-term elections after a positive year and then entered a pull-back, 50% of the time it ended the year down (6 out of the 12 occurrences since WWII).

To add some additional information to the analysis, I have identified the two mid-term election years that in my review most resemble 2014. The first is 1946, a year that I have written about in a previous Seeking Alpha article as a model for present financial market circumstances.  The reason the timeframes are so much alike is that in 1946 the nation was undergoing a post war transition, the Federal Reserve was pegging interest rates to the zero boundary and the federal government was implementing major budget cuts and tax increases (actually far more severe than the present day cuts).  The primary differences between the two periods are that in 1946 the U.S. did not have an unemployment problem and was running a trade account surplus. The time period exhibited a sharp inflationary burst followed by deflation that was eventually remedied through tax cuts and increased government spending later in the decade.  As shown in the above graph, the stock market in 1946 declined 19.69% peak to trough.

The 1998 time period is a second time period that holds a high resemblance to the current time frame.  The roaring late 90s with high internet company valuations and an accelerating stock market is a period that many readers should readily recall. It was also a period in which Alan Greenspan, although not in the same dollar magnitude and certainly not using Keynesian economic style monetary policy, was slowing down the rate of increase in Treasury purchases. The year was marked by crisis in the emerging markets, capped off by the Russian debt default. The crisis peaked in the summer, and moves to add liquidity to the market by the Fed eventually allowed the market to recover and end positive for the year.  There is no way of knowing whether the International market will exhibit geopolitical unrest that affects stocks in the coming year; however, I do expect that the extreme Federal Reserve monetary policy is very likely to be tested in some fashion as Janet Yellen takes the position of Chairwoman.

Given the events that drove the results in the two most similar historical years, the actual outcome in 2014 may be more driven by political events than investors may be pricing into the market at the present time.  Does the current fiscal and monetary policy combination that is revving up the stock market change if the Senate and House become controlled by Republicans? This uncertainty is likely to ride on the market beginning at some point this year.

Daniel Moore is the author of the book Theory of Financial Relativity: Unlocking Market Mysteries that will Make You a Better Investor.  All opinions and analyses shared in this article are expressly his own, and intended for information purposes only and not advice to buy or sell.

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