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May 13, 2018

Midterm Election: The Worst Six Months of the Markets

May has historically marked the start of the “worst six months” for stocks. Returns for the major stock indexes over the period of May through October have historically lagged those of the “best six months” (November through April). Worst shouldn’t be confused with terrible, as the S&P 500 index averaged a 1.5% gain for May through October periods between 1950 and 2017 according to LPL Financial Research. The returns for the Dow Jones industrial average are not significantly different.

Midterm election years are a bit different. CFRA Research’s chief investment strategist Sam Stovall calculates the S&P 500 as averaging a 1.1% decline when the worst six-month periods occur in a midterm election year. Though the sample size is small (Stovall’s data goes back to 1946), the average loss when the midterm election is held during a president’s first term is 3.0%. A longer study by professors Kam Fong Chan of the University of Queensland and Terry Marsh of University of California Berkeley found that the premium over the one-month Treasury rate for investing in stocks averaged –1.72% between the period of June through October during midterm election years occurring between 1815 and 2015.

Before using the negative return relative to the one-month Treasury rate as an excuse to leave the market, there are four things to consider. First, since 1946, the midterm election year performance of the S&P 500 between April and October has been a coin toss, up nine times and down nine times. Second, the magnitude of losses is not always big. Stovall's data shows four midterm years with single-digit May-October losses. His data also shows five double-digit losses for the S&P 500 over the last 18 midterm election years’ worst six-month periods: 1946: –20.9%; 1962: –13.4%; 1966: –11.9%; 1974: –18.2%; and 2002: –17.8%. Third, John Lynch and Ryan Detrick (the chief investment strategist and senior market strategist, respectively, of LPL Financial Research) calculated an average 5.5% gain for the S&P 500 over the May through October period during midterm election years when the index was above its 200-day moving average trend and the S&P 500 had realized a positive return during the previous six-month period. This has occurred nine times since 1950. This year just happens to be a midterm election year when stocks went into May with trailing six-month gains (yes, even with the January correction factored in) and the S&P 500 above its 200-day moving average.

There is one other thing to consider: the returns after the worst six-month period has ended. Historically, once the midterm elections are held, the returns have been very good.

Chan and Marsh found that the average annualized premium (return in excess of the one-month Treasury rate) for investing in stocks has been 13.24% during the period of December through April following all midterm elections since 1815. Their research shows “61% of the monthly equity premiums realized from December to April following midterms are positive.” They further described their findings as being “more pronounced in the last century.”

Put another way, the odds of summer and fall discomfort are elevated, but so are the odds of being compensated for it if you believe the historical presidential term cycle for the stock market will continue its normal pattern this year. There is no guarantee it will, of course. Arguments could be made in either direction. Bulls can point to strong earnings and continued economic expansion. Bears can point to valuations and political uncertainties (both domestically and internationally).

Whenever looking at data like this, it’s important to consider your investing horizon. Any summer or fall weakness in the stock market should not derail your financial plans, especially if you don’t need the money for at least five or 10 years, as long as you do not panic. (Money needed within six or 12 months should not be invested in the stock market regardless of what the outlook looks like.) The market will fluctuate up and down; this is why the long-term returns on stocks are as high as they are.

Those of you who feel the need to do something have a few options. One is to see if your portfolio needs to be rebalanced. If the bull market has put your equity allocations well above target, consider bringing them back down to the desired long-term level. Another is to make adjustments with a small part of your portfolio. This could give you the emotional satisfaction of doing something without tearing apart your entire strategy. A trend-following type of approach such as holding onto stocks as long as the S&P 500 or another broad benchmark stays above its 200-day moving average is an option for those of you who incorporate technical analysis into your strategies. (It helps to factor in a 1% below/above band to avoid excessive transactions.) Alternatively, you could follow Stovall’s rotation strategy by shifting toward health care, real estate and consumer staples. Those of you who are contributing to your savings could hold off on putting new dollars to work until the fall, albeit with the dual risks of forfeiting any gains that occur or being too nervous to get into the market should prices decline instead.

Whatever option you choose, make sure it fits into your long-term strategy and that you have a plan to follow once the so-called worst six-month period is over. Most importantly, realize that not acting in response to expected short-term outcomes is often the best strategy.

The Week Ahead

Earnings season will start to shift toward retailers, with Home Depot Inc. (HD) announcing its results on Tuesday and Walmart Inc. (WMT) releasing its earnings on Thursday. There will be companies from other sectors reporting as well, including fellow Dow component Cisco Systems Inc. (CSCO) on Wednesday. Joining these three companies will be seven other members of the S&P 500 plus many smaller companies.

The week’s first economic reports will be April retail sales, the May Empire State Manufacturing Survey, March business inventories and the May housing market index on Tuesday. Wednesday will feature April housing starts and building permits and April industrial production. The May Philadelphia Fed Business Outlook Survey will be released on Thursday.

Five Federal Reserve officials will make public appearances: Cleveland president Loretta Mester and St. Louis president James Bullard on Monday; San Francisco president John Williams on Tuesday; Atlanta president Raphael Bostic and St. Louis president James Bullard on Wednesday; Minneapolis president Neel Kashkari on Thursday; and Cleveland president Loretta Mester on Friday.

The Treasury Department will auction $11 billion of 10-year TIPS (treasury inflation-protected securities) on Thursday.

Courtesy of Charles Rotblut, CFA is the VP and Editor for American Association of Individual Investors (AAII). Charles is also the author of Better Good than Lucky. (EconMatters author archive here)  

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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