Midterm Stock Correction Bets Could Backfire

Election-Year Strategies Far From Certain

If you work on Wall Street or follow the markets closely, you have undoubtedly heard that “stocks typically correct in midterm election years”, which is a relevant and factual statement. Our purpose here is not to question the validity of anyone’s analysis, but rather to highlight the potential pitfalls in relying too heavily on statements like the one below:

Midterm election years are typically poor performers for most of the year until finding a bottom in the fall and beginning a rally which lasts well into the following pre-election year. The traditional approach to seasonality during a midterm election year shows the final high (prior to the long period of under-performance) in April.

Let’s assume we base our 2014 strategy on a correction starting in April and bottoming in the fall, which is what the midterm election year pattern calls for. Since we are in a bull market, it is logical to examine midterm years that occurred during bull markets. Going back 20 years, the years that fit that profile are 1982, 1986, 1990, 1994, 1998, and 2010.

1986 Did Not Get The Midterm Correction Memo

Can we find cases where investing based on the midterm correction theory backfired? Yes. Assume our strategy in 1986 was to (a) sell all our stocks on April 1, (b) move to a 100% short position on April 1, (c) wait for the “inevitable midterm” correction to (d) cover the short after stocks make a new low for the year in the fall, and (e) move back to a 100% long position in stocks. The chart of 1986 below highlights the risks of betting big solely based on the midterm correction theory.

Not only did the midterm strategy not work well in 1986, it also could have significantly impacted your returns in a negative manner in 1987.

If your strategy was to cover your short after stocks made a new low for the year in the fall, then you never would have covered the short in 1986. If you never covered the short, then you never went long either. Those decisions would have resulted in lagging a buy-and-hold S&P 500 investor by 86.46%, which is the loss on the short added to the missed opportunity on the long side of the market.

1994: Not A Text Book Midterm Year

Since 1994 was marked by fears about rising interest rates, we recently covered it from a strategy perspective. If your midterm game plan called for selling your stocks and going short on April 1, 1994, it would have been a painful decision. Rather than seeing the yearly 1994 low in the fall as the midterm schedule calls for, stocks made their low for the year on March 31, 1994.

Not only did the midterm strategy not work well in 1994, it also could have significantly impacted your returns in a negative manner in 1995.

If your strategy was to cover your short after stocks made a new low for the year in the fall of 1994, then you never would have covered the short in 1994. If you never covered the short, then you never went long either. Those decisions would have resulted in lagging a buy-and-hold S&P 500 investor by 78.92%, which is the loss on the short added to the missed opportunity on the long side of the market.

Moral Of The Story

Is there anything wrong with understanding seasonality or how stocks typically behave in a midterm election year? No, in fact it can be helpful from a preparation perspective. However, blindly following any seasonal or election cycle pattern violates countless “you are better paying attention than trying to predict” axioms that we have covered in the past:

1. You think you know what is going to happen next.
2. Trying to figure out what is going to happen, rather than paying attention to what is happening.
3. Thinking in certainties, rather than in probabilities.
4. Not understanding the concepts in the expression “the market does not care what you think”.

The links above discuss an alternative method to using the knowledge that stocks tend to correct during a midterm election year.

Today’s Fundamentals Matter, Not Yesterday’s

If stocks correct in line with the midterm election theory, which they may, it will be based on the fundamentals in 2014, rather than any magic connection to 1982, 1986, 1990, 1994, 1998, or 2010. On Tuesday, a report showed that the Institute for Supply Management’s index increased to 53.7 in March from 53.2 a month earlier, showing the industry was improving at the close of a winter-depressed Q1. From Bloomberg:

“People are looking for confirmation that the weakness we saw earlier in the year was, in fact, weather-related,” Walter Todd, who oversees about $990 million as chief investment officer of Greenwood Capital Associates LLC in Greenwood, South Carolina, said by phone. “Seeing better data confirms that it was a temporary slowdown in the economy and we should see a pickup.”

2014: Employment, Earnings, the ECB, and China

Since fundamental events in 2014 will determine whether stocks experience a correction followed by a low in the fall, it is important to pay attention to data as it becomes available. This Friday brings Wall Street’s favorite piece of economic data, the monthly employment report. Earnings season has already kicked off and will provide investors with another economic benchmark. From Zack’s:

Expectations for the Q1 earnings season as whole remain low, with total earnings expected to be down -1.8% from the same period last year on +0.9% higher revenues and modestly lower margins. As has been the trend for more than a year now, estimates for Q1 came down sharply as the quarter unfolded. The current -1.8% decline in total earnings in Q1 is down from +2.1% growth expected at the start of the quarter in January. With two-thirds of S&P 500 members typically beating earnings estimates in any reporting cycle, actual Q1 results will almost certainly be better than these pre-season expectations. But Q1 is unlikely to repeat the performance of the last few quarters when we would witness new all-time records for total earnings each quarter.

Another set of fundamental developments that could significantly impact equity prices is the potential for new stimulus and economic assistance measures from China and the European Central Bank; both were discussed on March 28.

Investment Implications - What Is Happening Now

If the midterm election year correction is coming, we know with 100% certainty that weakness must begin to appear on the charts. Therefore, as long as the charts are not screaming “the odds of a correction are increasing significantly”, then we should not let any seasonal or election year tendency drive what should be a rational, rather than fear-based, decision making process. While the S&P 500 chart below looks noisy and complex, the basic concepts are easy to understand. As of April 1, 2014, the S&P 500 still has an “it is okay to own stocks” look. We used the concepts from the chart below to successfully reduce stress related to the scary 1929 analogy; the same rationale can be applied to the midterm correction scenario.

As long as the hard and observable evidence aligns with the bullish case for stocks, we will continue to maintain exposure to the S&P 500 (SPY), an equally-weighted S&P 500 ETF (RSP), and technology stocks (QQQ). On Tuesday, our market model called for a relatively small chess move to reduce cash and increase our exposure to stocks. If the evidence begins to align with a stock correction, we are happy to reduce risk in line with the rate of deterioration.