[12/23/22] Regardless of how this year ends, statistically, next year should be much better.
The 4-year Presidential Cycle shows that year 3 (that's 2023), is the best year of all 4 years. In fact, since 1950, stocks have always gone up in the year after midterms, with an average 12-month forward return of 18.6%.
[9/30/22] It’s been a rough year so far.
40-year high inflation, which forced the Fed to aggressively raise rates in an effort to bring it down, has been weighing on stocks.
As tough as this year has been, I’m reminded of the comparison that was made between the first half of this year, and the first half of 1970.
This year’s first half performance (the S&P was down nearly -21%), was strikingly similar to that of 1970 (also down -21%). And in both periods, high inflation was an issue.
But in the second half of 1970, the S&P was up 27%.
Of course, that doesn’t mean that’s how it’ll go for the back half of this year. But it doesn’t mean it won’t either.
Granted, the last few months haven’t been any easier. And there’s only 3 months left of this year. But with plenty of economic positives backstopping the economy right now, not the least of which is a strong labor market, there’s definitely a chance that the market is being too pessimistic.
While we unofficially saw a recession after Q2 GDP fell by -0.6%, which followed Q1’s -1.6% (two quarters in a row of negative GDP is the technical definition of a recession), consumer demand remained strong throughout. So did corporate earnings. And the jobs market stayed sizzling hot.
You can also see that in the GDI numbers (Gross Domestic Income), which measures U.S. economic activity via the income earned for these activities. Usually, the GDI and GDP (Gross Domestic Product) are statistically very similar. But unlike the GDP, the GDI was up in the first half of the year with a positive 0.5% annualized growth rate, while GDP was down.
Will these two measures converge? If so, will GDP rise to meet GDI, or will GDI fall to meet GDP? Or maybe a little bit of both? TBD. But, at the moment, GDP forecasts are pointing to plus signs for the rest of the year.
Q3 GDP is only expected to eke out a 0.3% gain. But Q4 is expected to be better, with full year estimates showing another year of growth. (It’s no longer a recession when the economy starts growing again.)
And the Fed is predicting 2023 to be even better still with a 1.8% GDP growth rate.
So there’s plenty of positives in the market right now. (The market happens to be ignoring them at the moment. But they are there nonetheless.)
And with the market seemingly pricing in the worst-case scenario (deep and long recession), stocks are primed to rally once it looks like the worst-case scenario won’t come to pass (shallower and shorter recession).
Peak Inflation Is Behind Us
One of the key factors which will likely determine where the market goes from here, will be inflation, and therefore, interest rates.
Even though inflation is still too high, it has been ticking down for the last few months.
Headline inflation, according to the Consumer Price Index (CPI), is at 8.3% y/y, with core inflation (less food & energy) at 6.3%. That’s down from its peak of 9.1% and 6.5%.
While that dip is not a lot, and it’s a far cry from the Fed’s goal of getting it back down to 2%, the mere fact that it’s no longer making new highs, and instead is ticking lower, is a step in the right direction.
(Oil prices, for example, have fallen sharply. After trading over $130 a barrel, crude oil is now trading at $82. That’s a decline of -37% in a matter of months. And that’s helping to ease inflation concerns.)
A few months ago, many were expecting inflation to soar above 10% or more. Now, expectations are for it falling to 5-6% next year, with the core rate falling even lower.
And that means the Fed may not have to raise rates as much as people are fearing.
Are Stocks Undervalued?
Let’s also not forget that valuations are down.
The P/E ratio for the S&P is at multiyear lows, and is trading below its five-year average.
And that makes stocks a bargain.
Of course, if earnings drift lower, valuations will creep up. But there’s plenty of room for stocks to remain relatively cheap.
And the earnings outlook is still forecasting growth.
Add in another trillion dollars in stimulus between the CHIPS Act and the Inflation Reduction Act, and that should extend the growth outlook even further.
How Do Stocks Perform Around Midterms?
Many are familiar with the Presidential Cycle and the markets. But many may not know that the Presidential Cycle covers all for years of a presidency.
Of particular interest is the midterm portion of the cycle, which is where we are right now.
And historically, it’s amazing to see how favorable this cycle is for investors at this point in time.
Developed by Yale Hirsch, of the Stock Trader’s Almanac, the theory suggests that the stock market follows a pattern which correlates with a U.S. president’s four-year term. The election cycle consists of the post-election, midterm, pre-election, and election years. 2022 is an example of a midterm year, i.e., the second year in the 4-year presidential cycle.
In the first two years after an election, the second year tends to be the weakest. In fact, it’s the weakest of all four years. Congressional elections take place – and with them, they bring the potential to shift the political backdrop.
Hirsch discovered that wars, recessions, and bear markets (sound familiar?) tend to start in the first two years of a president’s term. This year, the market entered the weak spot of the cycle. And with an aggressive Fed, high inflation, and the ongoing Russia-Ukraine war, the weakness in stocks was amplified.
Those who know their market history will find it somewhat unsurprising that the start to this year was rough. The second and third quarters of midterm years are historically quite weak. (History repeating itself once again.)
But more prosperous times typically lie ahead in the latter half of the cycle.
In fact, we’re entering the most bullish part of the calendar – Q4 of year 2 in the 4-year presidential cycle (the second-strongest quarter of all 16 quarters), sporting an average return of 6.6% (since 1950); and Q1 of year 3 (the strongest quarter of all 16 quarters), with a 7.4% average gain.
And when we factor in that the third year of the presidential cycle has historically witnessed the best performance of all four years, the outlook for stocks looks even brighter.
-- Kevin Matras, Weekend Wisdom, 9/30/22
