Why Year 3 of the Presidential Cycle Hasn't Gone The Way Everyone Expected

Summary: Year 3 of the "Presidential Cycle" was expected to post a gain of over 20%. Instead, SPX is down 3% from a year ago. Why? The set up was all wrong, which brings up a basic principle in analyzing markets: patterns work for a reason, and if that context is missing, the pattern will probably fail. In the event, this is what has happened.

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A year ago, we wrote a post on why "Year 3 of The Presidential Cycle Is Unlikely To Go The Way Everyone Expects" (here). At the time, SPX had risen 10% in the prior two weeks. The consensus was firmly in the camp that this performance would continue. After all, since 1950, SPX has risen an average of 22% during this phase of the cycle. In the past 60 years, Year 3 has never provided a negative return.

Weekly Market Summary

Summary: The first drop in equities was more than a month ago, yet price has not come within even 2% of the original low since then. Despite this, bearish sentiment continues to rise as if new lows were being formed. This is a strong positive. The infamous month of October arrives this week: volatility is likely to remain high, but our view is the risk/reward of buying sell-offs is very attractive on a year-end basis.

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Since the late-August drop in equities, we have discussed how we expect markets to react in the weeks and months ahead (post and post). Here is a short recap:

1. Our assumption is that equities are not in the process of starting a bear market, but simply correcting within the context of an ongoing bull market.
2. Why? Most bear markets coincide with a looming recession. It's not all perfect but the balance of economic evidence is positive (a recent post on this is here).
3. US equities have risen 80-100% in the past 3 years, and indices have been higher every year for six years in a row. This has been a strong uptrend.
4. Corrections within bull markets are normal. For context, this is the first correction in more than 3 years. Again, the uptrend has been strong. Bull markets do not end with the first correction in several years. 
5. When price falls, the price pattern looks scary and breadth looks terrible. Stories in the media emphasize the risks of investing. These are when longer term lows form. More likely than not, that is where equity markets are now.
6. After waterfall events like that in August, indices will often rally as much as 10% and also retest their lows a month later. That is the pattern we are witnessing now. It's not hard to imagine that this process will continue into October.
7. The increase in volatility makes short term activity subject to wild reversals, exactly as we have seen in the past month. This is likely to persist into the next month.
8. On a year-end view, the washout in breadth and bearish sentiment provides an attractive risk/reward to accumulate equities on sell offs near the August low.

Two weeks ago, our expectation was that seasonally bullish September OpX could rally SPY back to the start of the waterfall from late-August, between 202-204. In the event, the high last week was 202.9. The week after September OpX is the weakest of the year for equities: our target was the bottom of the past one-month range:185-190.  In the event, the low this week was 190.6 (original chart and comments here). 

Interview with Financial Sense on Investor Positioning and the Unlikely Bear Market

We were interviewed by Cris Sheridan of Financial Sense on September 16, the day before the FOMC rate decision. During the interview, we discuss the macro environment, what the Fed is likely to do, what investors have been doing during the sell off, what the set up for a possible bear market would look like and what is likely to happen next in the equity market.

Our thanks to Cris for the opportunity to speak with him and to his editor for making these disparate thoughts seem cogent.

Listen here.

If you find this post to be valuable, consider visiting a few of our sponsors who have offers that might be relevant to you.

Fund Managers' Current Asset Allocation - September

Summary: Overall, fund managers' asset allocations in September indicates the strongest bearishness since 2012. This is bullish for equities, especially in the US.

Fund managers' cash remains at the highest levels since the panic of 2008-09. This is normally contrarian bullish.

Moreover, allocations to equities dropped over the past two months to the lowest level in 3 years. Equity allocations are now below average and at levels where prior lows in price have formed.

One concern is that fund managers remain very overweight "risk on" sectors: allocations to discretionary, banks and technology are above their means. Allocations to defensive sectors, like staples, are still low. In other words, there's a chance fund managers will make a further run to safety in the coming month(s).

Regionally, allocations to the US and emerging markets are at low levels from which they normally outperform on a relative basis. The dollar is also considered highly overvalued, and BAML fund managers have been prescient in the past in calling turning points in the dollar.

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Among the various ways of measuring investor sentiment, the BAML survey of global fund managers is one of the better as the results reflect how managers are allocated in various asset classes. These managers oversee a combined $600b in assets.

The data should be viewed mostly from a contrarian perspective; that is, when equities fall in price, allocations to cash go higher and allocations to equities go lower as investors become bearish, setting up a buy signal. When prices rise, the opposite occurs, setting up a sell signal.

To this end, fund managers became very bullish in July, September, November and December 2014, and stocks have subsequently sold off each time. Contrariwise, there were some relative bearish extremes reached in August and October 2014 to set up new rallies. We did a recap of this pattern in December (post).

Let's review the highlights from the past month.

Fund managers cash levels remained over 5% for a third month, the first time it's been this high for three months in a row since late-2008 and early-2009. This is an extreme and it's normally very bullish for equities (green shading).  

Weekly Market Summary

Summary:  It's never perfect in equity markets; when price patterns and breadth look healthy, sentiment is overly bullish and further appreciation becomes limited. When price falls, the price pattern looks scary and breadth looks terrible but sentiment becomes too bearish. These are when longer term lows form. More likely than not, that is where equity markets are now.

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The bottomline on the markets right now is this: waterfall events (like late August) tend to reverberate into the weeks ahead, with indices rallying 10% and also retesting the lows. We are probably still in the middle of this period and it's not hard to imagine that it will continue into October.  The increase in volatility makes short term activity subject to wild reversals, exactly as we have seen over the past 3 weeks.

On a year-end view, the washout in breadth and bearish sentiment provides an attractive risk/reward to accumulate equities on sell offs. With FOMC and OpX upcoming, the next two weeks might provide another opportunity to do so. All of this assumes, as we do, that equities are not in the process of starting a bear market, but simply correcting within the context of an ongoing bull market.

The fall in equities has a majority of investors concerned that a bear market is unfolding. This is not surprising: every significant drop in equities makes price patterns look scary, breadth look terrible and brings out stories in the media emphasizing the risks of investing. All of this explains why sentiment during corrections gets knocked down to its knees, as it has been now. The twist is that this is how every new uptrend in a bull market begins.

US equities have risen 80-100% in the past 3 years, and indices have been higher every year for six years in a row. To date, US equities are trading about 5% lower in 2015. This weakness in the midst of a bull market is not unusual.

Highlighted below (in yellow) is the annual return during every bull market in the past 60 years (non-highlighted years are bear markets). In red are years with low returns. Low returns and losses are a feature of every sustained bull market. 2015 is likely to be one of those years, but that does not imply that the bull market has ended.

Live With Howard Lindzon, CEO of Stocktwits

I'll be speaking with Howard Lindzon, the CEO of Stocktwits, at Stocktoberfest on October 19 in Coronado, CA. I hope to see many of you there.

Warning: I follow presentations by PhDs in math and psychology who have authored entire books on investing.

Details are here.

September Macro Update: Majority of Macro Data Remains Positive

Summary: This post reviews the main economic data from the past month.  The balance of the data continues to be positive. There is little to suggest the imminent onset of a recession.

• Employment growth is the best since the 1990s, with an average monthly gain of 243,000 during the past year.  
• Compensation growth is positive but not accelerating: 2.2% yoy in August.
• Personal consumption growth the last two quarters has been the highest in 8 years.  2Q15 real GDP grew 2.7%, near the upper end of the post-recession range. 
• Housing starts are at an 8 year high. New home sales in July rose 26% yoy. 

The main negatives are:

• Core durable goods growth fell 4% yoy in July. It was weak during the winter and there has been little rebound since. Industrial production has been weak, growing at just 1.3% yoy, one of the lowest rates in the past 15 years. 
• The core inflation rate remains under 2%. It is near its lowest level in the past 3 years.  

Bottomline: the trend for the majority of the macro data remains positive. The pattern has been for the second half of the year to show increased strength. That appears to be the case in 2015 as well.

Prior macro posts from the past year are here.

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Our key message over the past year has been that (a) growth is positive but modest, in the range of ~3-4% (nominal), and; (b) current growth is lower than in prior periods of economic expansion and a return to 1980s or 1990s style growth does not appear likely.

This is germane to equity markets in that macro growth drives corporate revenue, profit expansion and valuation levels. The saying that "the stock market is not the economy" is true on a day to day or even month to month basis, but over time these two move together. When the diverge, it is normally a function of emotion, whether measured in valuation premiums/discounts or sentiment extremes.

Let's review each of these points in turn. We'll focus on four categories: labor market, inflation, end-demand and housing.


Employment and Wages

The August non-farm payroll was 173,000 new employees plus another 44,000 in revisions. In the past 12 months, the average gain in employment was 243,000, the highest since the 1990s.

Monthly NFP prints are normally volatile. Since 2004, NFP prints near 300,000 have been followed by ones near or under 100,000. That has been a pattern during every bull market; NFP was negative in 1995, 1996 and 1997. The low print of 119,000 in March fits the historical pattern.