US shares after quarterly reports and midterm elections

US shares after quarterly reports and midterm elections

15 November 2018Reading time: 4 minutes
Theme: The reaction to the mid-term election says that you should ignore the mid-term election and focus on capital flows and macro

The United States recently held mid-year elections, and as expected, the Democrats took over the power of the Republicans in the House of Representatives.

Historically, the stock market has developed strongly during periods of a divided congress, ie where Democrats and Republicans have power in each chamber (Senate and Representative House). The logical reason for the pattern is usually said that a shared congress makes it more difficult to make true unilateral and harmful decisions.

US stocks surged after the election. The rally was one of the biggest post election rallies in 40 years. But after only three days, the upswing has already been eradicated.

In retrospect, it looks as though the surge was just the last part of the reflexive bounce after the 10 percent correction for the US S & P 500 Index in October.

The response in the United States sends mixed signals:

The S & P 500 has been very strong in the last 5 years, almost regardless of political and economic news:

The report season for the third quarter was unusually strong on paper, one of the strongest ever, yet stock markets corrected sharply down during the reporting period.

At first glance it may seem strange that strong earnings reports and a "good" election result are met with falling prices, but it is actually quite easy to find an alternative interpretation.

The US economy is at its absolute peak after, among other things, President Trump's tax cuts. This means that the central bank will continue to raise its key rate. At the same time, it is obvious that the effect of stimulus measures is temporary and that there is no free capacity in the economy, which reduces growth potential in the future.

When the macro situation can be described as a string stretched to its limit, with record high valuations, very low unemployment and temporary high growth, and it meets a "razor blade" in the form of rapidly rising interest rates, it's only a matter of time before something has to change.

Given that the CAPE is about three times as high as the average and the one-year interest rate has risen from 0.75 percent to 2.75 percent in less than two years, the upswing has to be explained, not the decline.

American 1-year government bond rate:

The upturn has been liquidity driven and has been strengthened by a very successful buy the dip mentality. But now the sentiment appears to be close to turning and when enough have lost on their bargain purchases once again, the trend of decline and liquidity are picked out of the market.

When some pundits say that the stock market will not fall significantly without a recession and that there is no sign of the latter, it may be worth remembering that growth is almost always high and unemployment low as close as just 1-2 quarters before a recession hits.

One last piece of the puzzle, for those who ask themselves whether there’s a buy or sell opportunity after the mid-terms and quarterly reports, consist of Goldman Sach's bear indicator. It is now at one of its three highest levels since the 1950s; and a recession has almost always followed short of similar signals. The indicator includes unemployment, valuation, purchasing manager index, interest rate curve and inflation.

So, the mid-year election in the US was positive, but the market still sends out a negative signal and a willingness to sell the rise. This is also happening after one of the most positive quarterly reports ever, but then the stock market fell paradoxically by ten percent in a month.

The interpretation is that there are completely other factors that control the flow of capital and the willingness to take risks.

With high values, increasing attractiveness of alternatives such as interest rates, precious metals and agricultural commodities, as well as rising interest rates that lead to increased costs for everything from housing and stock loans to investments, a single reporting period or election run will be almost completely irrelevant.

So forget about what happened in October and November and consider whether it's time to change strategy.

When you have two equal strategies that gave similar performance over a century, it's logical to switch from the one that worked unusually well for years to the one who was lagging. Otherwise, one must assume that one strategy has suddenly become dominant forever. In practice, therefore, in today's case, it is better to switch from Buy and Hold Forever to Dare Sell Expensive and Buy Cheaply Later. With the adjusted CAPE of 45 and ten years of stock market rally behind us, it does not feel like any major risk of reducing exposure to the stocks and markets that have been the strongest.

The questions you need to ask yourself are 1) If you dare to believe that a divided congress will lead to a strong economy and a return for cyclical companies over defensive, or 2) whether macroeconomic imbalances and signs of weakness after the reporting period and the mid-term elections are pointing to it being time to reduce your shareholding considerably, especially when it comes to cyclical companies.

@Mikael Syding

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This information is in the sole responsibility of the guest author and does not necessarily represent the opinion of Bank Vontobel Europe AG or any other company of the Vontobel Group. The further development of the index or a company as well as its share price depends on a large number of company-, group- and sector-specific as well as economic factors. When forming his investment decision, each investor must take into account the risk of price losses. Please note that investing in these products will not generate ongoing income.

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27/11/2022 16:47:45