Market & Investment Allocation Update
July 29, 2022
For this letter, we’re going to zoom way out and look at some bigger picture cycles and patterns and how they’re relevant to how we’re managing your portfolio.
Do Bad First Halves Automatically Lead to Great Second Halves?
First, there’s been a lot of chatter in the media about how when stocks have a terrible first half of the year, they almost always have a good second half of the year. In light of the market rally since the middle of June, that idea would seem to have some validity.
However, the chart below shows the top 10 worst first half of the year starts compared to this year (this year is the black line). The takeaway here is there were plenty of years that ended up even lower than their negative first halves of the year. Bear that in mind when you see the idea presented that the worst is likely behind us.
The 4-Year Presidential Election Cycle
Next, I want to introduce you to the concept of the 4-year presidential election cycle as it relates to patterns in the stock market. There is a body of research that tracks average market performance for the post-election year, midterm year, pre-election year and the election year. The idea here is that the motivations, behavior and votes of politicians tends to rhyme during each year of the 4-year presidential election cycle creating patterns in the way the stock market behaves during any one of those year.
While I’m oversimplifying here, the key takeaway to this cycle is that the worst year of that 4-year cycle is the midterm year. And the worst of the worst of worst is midterm years with first-term presidents, which is exactly what we have this year. This sets us up for the majority of this year being, on average, the “Weak Spot” in this 4-year presidential election cycle (see chart
below which uses data from 1949 to 2021).
But the good thing about the market turmoil in midterm years is that that Weak Spot tends to set us up for the Sweet Spot towards the end of midterm years and following through to pre-election years.
Which Party in Power is Best for the Market?
Finally, the chart below shows the performance of the Dow Jones Industrial Average with different combinations of parties holding presidential and congressional power. The takeaway here is that the best combination of political power for Dow returns is a Democrat president and Republicans holding the majority in Congress (green bar in chart below). Of course this not a commentary on either political party, but an apolitical look how the market performs under different combinations of parties holding presidential and congressional power.
Executive Summary of These Macro Ideas
So to sum up these macro themes presented in the charts above:
1) Just because it was a terrible first half of the year for the indexes doesn’t mean it will automatically be better in the second half. We must continue to remain vigilant.
2) This year has so far followed the historical pattern of a “Weak Spot” in the 4-year presidential election cycle. But this weak spot has tended to set the market up for a sweet spot towards the end of the midterm year.
3) The optimal political power combination for Dow Jones Industrial Average returns is a Democrat president and Republican Congress. This is likely what we’ll have after the midterms right when we hit the historical sweet spot.
We could be looking at phenomenal buying opportunity later this year given the combination of the sweet spot in the 4-year presidential election cycle and the combination of parties likely to be in power in Washington.
Zooming In to the Coming Weeks
The rally we’ve seen in the stock market is not unexpected and I think the probabilities favor that it is not durable and likely yet another bear market rally. (A bear market rally is a strong rally in a downward trending market.)
July is historically a good month in the market with August, September and October returning us to seasonally weak months. One thesis we’re working with is the idea that the S&P 500 Index rallies back to around the 4,080-4,100 area and then at some point of the coming weeks/months, retests the lows. So far that thesis is intact so we continue to remain in cash for accounts custodied at TD Ameritrade.
One thing I would like to point out is that while we think it’s unlikely the worst is over for stocks, it seems more probable that the worst could be over for bonds. So for accounts custodied at TD Ameritrade where we have an allocation for income, it’s possible that you’ll see us begin to put bond money back to work in the coming weeks.
Are We in a Recession?
Two consecutive quarters of negative GDP have generally defined recessions in the past.Yesterday’s GDP report confirmed a second consecutive quarter of negative GDP. So yes, in all likelihood the economy is in some kind of recession.
But I believe the more important question is this: will this recession be moderate or severe? And depending on that answer, what will the Fed do and how will investors respond? That’s ultimately what’s driving this market: what will the Fed do and how will investors respond. That’s the question we’re diligently trying to answer in the background for you.
The consensus view right now is that inflation has peaked so the Fed’s priority now shifts from tightening financial conditions to easing financial conditions to a greater or lesser degree depending on how severe the recession actually is. It’s possible this is the case which would mean interest rates have peaked for now and we could begin putting bond money back to work as I mentioned above.
I’m not so sure that inflation has peaked. The Fed’s preferred inflation indicator jumped to 40-year highs this morning, that’s not a good sign. Also, if oil were to make a move back towards its highs for the year, for whatever reason, that would further fan the flames of inflation.
Which brings us back to the same place we’re been in previous months: if inflation doesn’t moderate as is the consensus view, the Fed’s hands are tied and they must battle inflation by tightening financial conditions. Only now it will be with a slowing economy.
This is why we must continue to be extraordinarily diligent with how we choose to allocate your capital.
I welcome any questions that you have.
David W. Shepherd Jr. CFP®
6300 E El Dorado Plaza, Suite A200
Tucson, AZ 85715
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