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Will the Election Outcome Affect the Stock Market?

Posted by RAA on Oct 5, 2016 4:00:00 PM


Market_Matters_Icon_medium.jpgIf history proves a useful guide, the outcome of the upcoming presidential election in the US is unlikely to have a major bearing on the performance of the stock market. Economics, in the end, always trumps politics (no pun intended).

This doesn’t mean that if the election goes one way or the other that there couldn’t be a potential downdraft in the market, but nothing lasting, in our opinion. The checks and balances of our political system help to explain why elections in the US have historically had little bearing on the performance of the stock market. Let’s drill down and see why.

RATE CYCLE PHASES

Bank Credit Analyst (BCA) did a study three years ago asking the question…what have the S&P 500 returns been during interest rate cycle phases dating back to 1961, which includes what is happening today?

Their study in 2013 divided the rate cycle into four distinct phases:

  • Phase One: Easy policy accommodation, but the federal funds rate is rising.
  • Phase Two: Policy is tight and the federal funds rate is still rising.
  • Phase Three: Policy is tight but the Fed is cutting rates.
  • Phase Four: Policy is easing and the Fed is cutting rates.


Without going into all of the details, as space is limited, the two phases that produced the best longer-term returns were phase one and phase four regardless of any presidential elections. Phase four saw an average annualized return of 23% while phase one saw a return of almost 11%. Phases two and three saw slightly positive returns (2-3%) and negative returns, respectively. We are currently in phase one.

The most powerful phase of a new bull market is driven by abundant liquidity, as we have seen since mid-2009. The second phase of most bull markets occurs when this “excess liquidity” attempts to pass the “liquidity baton” to earnings. The Fed withdraws liquidity from the system via higher interest rates, with the offset being that earnings estimates go higher as investors have increased confidence in the strength and longevity of the business cycle. This is where we are now.

In transferring liquidity to earnings, the most troubling part is whether the current difference between GDP growth (low but stable) and earnings, which seem to be somewhat contracting, or growing but only very slowly, will actually be realized. The problem becomes that even if demand growth does not disappoint, the downward pull from declining profit margins and rising labor costs will make it difficult for corporations to achieve top-line earnings growth. BCA’s profit model indicates that earnings growth may be in the low single digits, hardly what Wall Street analysts have been predicting, which has been in the double digits. This could leave a lot of room for disappointment.

OUTLOOK FOR STOCKS

Having said this, the question is…will another increase of 25 basis points (1/4 of 1%) in the federal funds rate pose a large hurdle for stocks? We don’t think so, but like the BREXIT vote in the UK, no one really knows. Several market indicators, including BCA’s Monetary Index and the St. Louis Financial Stress Index, indicate that monetary conditions are still easy and that there is currently no stress in the financial markets. On a cyclical basis this is good for stocks. The bottom line is that risk assets (stocks) are still benefiting from the liquidity in the system. However, our main concern continues to be that the hand-off from liquidity to earnings remains bumpy during this cycle, primarily because we are in a low growth and potentially deflationary environment, which makes it tough for corporations to increase their top and bottom line earnings growth.

In summary, while the US election on November 8th makes for good political theater and fodder for journalists, it is the economy that, in the long term, drives the equities market. As a wise investor once said: in the shorter term, the market is a voting machine, but in the long term it is a weighing machine, as it weighs the evidence and not the emotion of shorter-term investors.

In conclusion, the current lukewarm sentiment towards equities means that without solid fundamentals, stocks will remain vulnerable to perceived risks (elections, geopolitical risks, a stronger dollar, etc.) As we have alluded to above, the lackluster earnings picture remains the most relevant threat to risk assets on a cyclical basis.

Please contact us at (972) 684-5923 if you have any questions.

 

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Disclaimer: This blog is intended for informational purposes only and should not be construed as individual investment advice. Actual recommendations are provided by RAA following consultation and are custom-tailored to each investor’s unique needs and circumstances. The information contained herein is from sources believed to be accurate and reliable. However, RAA accepts no legal responsibility for any errors or omissions. Investments in stocks, bonds, and mutual funds may increase or decrease in value. Past performance is no guarantee of future results. Any of the charts and graphs included in this blog are not recommendations for the purchase and sale of any security. 

Topics: Investment Updates