Adam Hamilton November 5, 2010 2652 Words
The highly-anticipated 2010 mid-term elections are finally over, a huge relief if you hate politics and government meddling in our lives as much as I do. Now that the American people have fired the arrogant politicians who refused to listen to the will of their tax-paying constituents, we can get back to focusing on the financial markets. So how do the stock markets tend to perform after mid-term elections?
This question is simple enough, but it usually leads to multiple scenarios. What if the Republicans gain a majority in one house of Congress when the President is a Democrat? What if Republicans gain a majority in both houses? What if the houses are switched around? What if the parties are switched around? The strange people in this world who somehow like government endlessly debate this stuff.
For students of the markets, an entirely-different concern fractures the possibility set into smaller pieces. Where did the mid-term election occur within the bull-bear cycles? Mighty secular bulls and bears dominate the stock markets for the better part of two decades each. And within these behemoths, much-shorter cyclical bulls and bears gradually meander. So what if a mid-term election (MTE) happens in a cyclical bull within a secular bear? How about during a cyclical bear within a secular bull? You get the idea.
Obviously the Republicans overwhelmingly won the House this week, but fell short in the Senate. And we are burdened with a Democratic President. And the markets are currently enjoying a cyclical bull within the secular bear that was born in 2000. So should we only look at past MTE years matching 2010’s conditions? Not necessarily. That really limits the sample size, and though the present often rhymes with history there is never a perfect match.
So for this study on how stock markets tend to perform after MTEs, I decided to consider all MTE years and their respective following years over the past half-century. Though the balance of power shifted both ways between the parties, and different presidents were in office, and the markets were at differing points in their all-important bull-bear cycles, I included them all. Combining all mid-term elections ought to average away their various differences, leading to the true post-MTE stock-market tendencies emerging.
I considered the last dozen mid-term elections before 2010’s, which start way back in 1962 when John Kennedy was President. I used the flagship S&P 500 stock index as a proxy for the stock markets’ performance following these MTEs. But over time this index’s prevailing levels gradually rose, from the 50s in 1962 to the high 1100s this year. So in order to keep all the percentage moves perfectly comparable across decades, each MTE year had to be individually indexed.
Since we traders like to think in terms of calendar months, and the exact election date in early November changes from MTE to MTE, I set each year’s base index equal to 100 as of the last trading day in October. No matter what the absolute SPX level, if it rallied from an indexed level of 100 to 105 it gained 5%. After this indexing process, I charted each individual MTE year and its subsequent year to see any outliers. Then I averaged all dozen of these MTE indexes since 1962. The end result was this fascinating chart.
For months now I’ve been hearing that MTEs are good for the stock markets, but I hadn’t seen the hard numbers. I figured maybe we could hope for a 5% to 10% S&P 500 (SPX) rally over the subsequent half year or so. But boy, I was way too pessimistic! The reality of the stock markets’ post-election performance after every MTE year since 1962 is far more bullish than I imagined.
Though each individually-indexed MTE and its following year is spilled out above in yellow like a mess of spaghetti, note the center-mass trend. It is powerfully bullish for the most part. While there are a few outlying years that were considerably weaker, in general the post-MTE performance of the stock markets has been very strong. And this is across all historic MTE outcomes and bull-bear-cycle positions.
The red line is the mean of all the yellow lines, the average indexed performance of the SPX after the last dozen mid-term elections. And it is nothing short of stunning! By early January after a mid-term election, the SPX has been up 5% on average. By mid-February this doubles to +10%. Then in mid-April it hits +15% before relentlessly powering to +20% by early July. These are big, big numbers for stock markets!
A 20% general-stock-market rally in a year is considered outstanding performance, and after the last dozen MTEs we’ve hit that stellar metric in just 8 months! This is wildly good, and occurred regardless of which parties gained or lost and where the stock markets happened to be within their broader bull-bear cycles. If I hadn’t crunched these numbers myself, I would never have believed such a big average post-MTE rally.
And interestingly this performance wasn’t dependent on how the SPX had performed in September and October leading up to the mid-term elections. This year the SPX soared 12.8% in September and October before Tuesday’s MTE. So a lot of traders understandably make the case that the stock markets are overbought and need to correct regardless of post-MTE tendencies. But history doesn’t bear this out.
In 2010, the indexed SPX was at 91.3 as of September 1st, or 91% of where it closed at the end of October leading into the MTE. Yet both 1982 and 1998 saw lower indexed values, 88.4 and 90.5 respectively. This means the SPX enjoyed bigger pre-MTE rallies those years than we saw in 2010. Yet at the ends of the following years, the indexed SPX finished at 123.3 and 133.7 respectively. Despite a big 2-month pre-election rally, the stock markets still surged 23% and 34% by the subsequent years’ Decembers!
So we can’t just dismiss out of hand the possibility of a big post-MTE rally this year simply because the stock markets were strong leading into it. In history pre-election performance didn’t matter, the stock markets still tended to rally regardless.
Whenever I index and average a bunch of different years, I always like to consider the outliers contrary to the trend I am trading to see what I can learn about the exceptions to the rule. And since this analysis is a very bullish omen for the stock markets, the downside outliers are of particular interest. They are divided into two groups, the early laggards soon after the elections and the late laggards a year or so later.
The worst performances by far soon after MTEs occurred following the 1974 and 2002 elections. But these are actually pretty easy to dismiss as likely today due to the bull-bear cycles. Late 1974 was the end of a mean cyclical bear that drove 48% SPX losses, and it climaxed in an extreme selling event that almost qualified as a full-blown panic like we saw in late 2008.
Back in late August 2010 when everyone was scared about that silly Hindenburg Omen, I discussed why a new panic or crash was almost impossible right now given the stock markets’ position in their bull-bear cycles today. Barring another extreme selling event like a panic or crash, we certainly aren’t going to see 1974’s sharp post-election plunge repeated in 2010.
And the poor performance following the 2002 MTE was for similar bull-bear-cycle reasons. A major cyclical bear (-49%) carved a secondary low in March 2003. We aren’t in a cyclical bear today, and one isn’t likely for some time yet. Most provocatively of all, despite the poor early performance following the 1974 and 2002 MTEs, the SPX was still up 22% and 25% by the ends of the following years’ Decembers! I’d happily take these kinds of gains any year, they are fantastic.
1994 was a milder laggard out of the gates, and that MTE was particularly interesting. That’s when Bill Clinton’s big-government socialism infuriated voters just like Obama’s did this year. The Republicans gained 54 House seats and 8 Senate seats, the most-comparable MTE episode to 2010’s from a political perspective. This year Obama’s hardcore anti-American Marxism cost the Democrats at least 60 House seats and 6 Senate seats. Good riddance to them!
And once again this early SPX lagging after the 1994 Republican Revolution soon gave way to big gains. By the end of 1995, the SPX was up 30% since just before the election. This was the fourth-largest post-MTE rally out of all dozen episodes since 1962! So if you’d prefer to look at today’s elections through a political lens rather than a market-cycle lens, the huge Republican victory this week bodes very well for stock-market fortunes.
In terms of late laggards, there were only two meaningful ones. And they really dragged the average down. After both 1986 and 2006, the stock markets finished the subsequent years up less than 10%. In the first case, the SPX had actually been outperforming to the upside by August 1987 following the 1986 MTE. It was up 38% by then, the best post-MTE rally by far. But the SPX was getting overbought and would soon succumb to the infamous 1987 crash.
On Black Monday (October 19th, 1987), the S&P 500 plummeted by a mind-blowing 20.5% in a single trading day! Provocatively this crash wasn’t driven by bull-bear cycles, but by the dawn of computerized trading. Computers had recently started trading autonomously, and that day program selling snowballed and drove an epic plummet like no other. Thanks to the resulting “circuit breakers” today, which cut computers’ access and then halt trading when losses grow too extreme, we’ll probably never see another 20%+ single-day crash.
The SPX’s performance after the 1986 MTE was a total anomaly, a unique fluke. But the reason the post-2006 MTE performance lagged was back to bull-bear cycles. The stock markets were late in a cyclical bull when the 2006 mid-term election occurred. After nearly doubling since late 2002, the SPX was largely consolidating high in the subsequent year of 2007. And then that cyclical bull finally peaked in October 2007, leading into the next cyclical bear. Nevertheless, the SPX was still up almost 7% by the end of 2007.
Once again this particular late-laggard scenario is almost impossible today. We aren’t in a mature cyclical bull by any means. Our current one only started in March 2009 and they tend to approach 3 years in duration on average. This means we ought to see a decent 2011 before we have to start looking for a top in early 2012. Today’s cyclical bull is simply too young to fear its imminent demise like we saw following the 2006 MTE.
Thus not only is the average performance of the stock markets following mid-term elections outstanding, but all the major below-average laggards are easily explainable. The conditions that led to these poorer performances simply do not exist today. The all-important bull-bear cycles that drove the majority of these laggards are not in similar topping positions today. So these past laggards certainly don’t dampen the inherent post-MTE bullishness we face right now.
So why are the stock markets strong following mid-term elections? Sentiment. Remember that the stock markets are the ultimate psychology game. When traders feel good, regardless of the reason why, they are more likely to buy stocks. Optimism inevitably drives capital inflows. The opposite is also true, when traders feel pessimistic and hope is waning, they are far less likely to invest. And mid-term elections breed a lot of hope.
Sadly politicians do whatever they want most of the time, ignoring the desires of their employers. This year is a perfect example. The American people were screaming for smaller government, as Obama has singlehandedly drove federal spending from the post-World-War-2 average around 20% of GDP up to 25%! We don’t want such a large and oppressive government, and never have. And the Democratic Congressmen spit in their voters’ faces by ramming through a wildly-unpopular government takeover of health care. The voter anger was incredibly intense, even among the fools who voted in these Marxists.
A Marxist is a socialist who advances class-warfare doctrine. Socialism is theft, which is why Americans have always hated it. And thankfully our society honors success, everyone strives to succeed in this great country where anyone who works hard can become a millionaire. The Democrats have spent the last couple years trying to steal more money from overburdened taxpayers while relentlessly attacking hard-working successful people. Success is celebrated in America, not scorned. Class warfare never flies here.
Mid-term elections breed hope because they give us taxpayers a chance to fire politicians who advance failed leftist ideologies and ignore our wishes. They work for us, but they seem to forget who they serve until election time. So kicking out the ones who hate the American way of life leads to a surge in optimism, and optimistic voters naturally invest more of their hard-earned surplus income in the stock markets. With our crushing government burden likely to be a little lighter, we can get on with creating jobs and building wealth.
And this natural American aversion to big government is not just a Democrat thing. When the Republicans grow government too big, usually by spending too much on imperialism and foreign wars, the American people kick them out too. We do not like big government, period. Our Constitution explicitly calls for a small and limited federal government, and we invariably punish politicians who forget this regardless of which side of the aisle they happen to be on.
Given this precedent, the stock markets are likely to enjoy an excellent rally between now and late spring. 20% gains in the SPX over this span are merely average based on history. From the SPX’s 1183 close at the end of October 2010, this would catapult this flagship index to 1420 or so. Interestingly, this is no problem at all within today’s secular bear since the upper resistance of its 17-year trading range runs around 1500. There is nothing in the bull-bear cycles that is likely to short-circuit a big post-MTE rally.
And while the gains in general stocks should be excellent, commodities stocks’ performance should dwarf them. Deep inside a secular commodities bull, commodities producers are thriving as prices rise. And this week the Fed just poured rocket fuel on commodities stocks by announcing its giant new campaign to monetize US Treasuries, a massive injection of pure inflation. This alone could drive one of the biggest commodities-stocks uplegs this bull has seen. Combined with the post-MTE rally, it is explosive.
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The bottom line is the stock markets tend to rally strongly following mid-term elections. This tendency holds true over the last dozen of these events, extending back nearly a half-century. Regardless of where the balance of power shifts, or where the stock markets happen to be in their bull-bear cycles, mid-term elections are very bullish. Average stock-market gains run 20% over the subsequent 8 months or so!
The reasons for this tendency are likely psychological. Voters can finally hold politicians accountable for ignoring their wishes, and this breeds optimism and hope. By firing those politicians abusing their power by growing government, investors can look forward to a brighter future. And as always when they are feeling better about things, they deploy more of their hard-earned surplus income into stocks.
Adam Hamilton, CPA November 5, 2010 Subscribe at www.zealllc.com/subscribe.htm