Midterm Elections Are Here. What’s Next For The Stock Market

Midterm elections are here. Lots of traders and investors are talking about “if the Republicans/Democrats win/lose, the stock market will (insert random guess here).

This “analysis” is no better than a coin toss. Nobody knows how the election will play out, and more importantly, nobody knows how the stock market will react to the election in the short-term. Guessing the news/politics is not a good use of one’s time.

Let’s analyze the stock market’s price action by objectively quantifying technical analysis. For the sake of reference, here’s the random probability of the U.S. stock market going up on any given day, week, or month.

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*Probability ≠ certainty.

Problems for the stock market in 2019

We expect the economy to deteriorate in 2019, which is why we’re looking for a bull market top sometime in mid-2019

CNBC published a very interesting chart recently.

Based on current estimates, year-over-year earnings growth will peak in mid-2019 and then start to fall.

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Past bull market peaks (1969, 1973, 2000, and 2007) have coincided with a peak in earnings growth or an already declining earnings growth.

Sentiment is starting to turn around

Last Thursday we said that “the Put/Call ratio is extremely high right now, which is medium-term bullish for the stock market”.

The Put/Call ratio’s 15-day moving average (3 weeks) is finally starting to come down.

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Here’s what happened next to the S&P 500 (historically) when the Put/Call Ratio’s 15 moving average fell 4 days in a row after being above 1.15 (i.e. right now).

*Data from 1995 – present

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As you can see, the stock market has a strong tendency to go up 2 months later. Now granted, some of these cases are overlaps.

This is the same study, excluding overlaps.

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Once again, the stock market has a tendency to go up 2 months later.

SKEW

SKEW seeks to understand the probability of a “black swan” event in the markets. Now that the stock market has already tanked in October, SKEW is very low.

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Here’s what happens next to the S&P 500 (historically) when SKEW fell more than -14% below its 200 day moving average (first case in 1 month).

*Data from 1991 – present

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Let’s increase the sample size by relaxing the parameters.

Here’s what happens next to the S&P 500 (historically) when SKEW fell more than -10% below its 200 day moving average (first case in 1 month).

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As you can see, the stock market tends to go up 6 months later.

The case for a retest

I continue to think that the stock market has a slightly greater than 50% chance of falling in the short term (i.e. next 1-2 weeks).

The S&P 500’s breadth has bounced off of extremely low levels.

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Here’s what happened next to the S&P 500 (historically) when SPXA200R (the % of S&P stocks above their 200-day moving averages) fell below 35% and then rose above 45% within 2 weeks.

*Data from 2004 – present.

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As you can see, the stock market tends to fall a little in the short term.

What not to worry about

The S&P and VIX (volatility index) went up together today. Is this something to worry about?

No.

Here are all the historical cases in which the S&P went up more than 0.5% while VIX went up more than 2%.

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As you can see, this has happened 94 times from 1990 – present. The stock market’s forward returns are no different from random. This is neither consistently bullish nor bearish for the stock market.

Conclusion

Our discretionary technical outlook remains the same:

1. The current bull market will peak sometime in Q2 2019.
2. The medium-term remains bullish (i.e. trend for the next 6-9 months). Volatility is extremely high right now. Since volatility is mean-reverting and moves in the opposite direction of the stock market, this is medium-term bullish.
3. The short-term is slightly bearish. There’s a slightly >50% chance that the S&P will fall in the next 1-2 weeks. This probability isn’t exceptionally high, so I wouldn’t bank on it.
4. When the stock market’s short-term is unclear (as it is most of the time), focus on the medium-term. Step back and look at the big picture. Don’t lose yourself in a sea of noise.