The stock market is a “one-act play.” The story remains the same; it’s just the players that change.
"Emotionally draining" is a term we would use to describe investor sentiment over the last few weeks. After appearing to find a significant bottom in mid-March, the stock market surprised most analysts, quickly changed direction, and fell further. Now into the second week of May, we are still searching for a bottom that can provide some support and instill confidence. Currently, negative headlines occupy most of the media outlets, with little written about any positive signs of hope. For the time being, the market remains hyper-focused on the negative factors, which continue to weigh in on stock prices. Pessimism often sounds more intelligent and more convincing than optimism. If something is not going well, it's human nature to think that it will continue going in this direction. However, we all know deep down that just about everything is temporary. At some point (maybe soon), "fear" will turn into "fear of missing out," just as it always does.
Although we know these periods of weakness and heightened volatility will end, the challenging part is getting to that point. The market can stay emotionally irrational for as long as it wants. It’s essential to lean on past market history to provide objectivity when we experience a market like we are in now, where there seems to be no light at the end of the tunnel.
Since January, we have been writing about how strange Midterm Election years are for the stock market. For unknown reasons, additional market volatility and weakness always show up between the start of the year and the Midterm election in November. So far, 2022 has not been the exception. Prices are down, emotions are high, and it is difficult to look past the current situation and even more challenging to see what opportunities may lie ahead.
The table below will help illustrate the weakness typically seen in the S&P 500 during Midterm Years and the massive gains traditionally earned coming out of a Midterm bottom. Dating back to 1930, the S&P 500 on average, declined -14.71% in value from the end of the previous year until the Midterm bottom is reached. Currently, we are running a little ahead of the traditional pullback levels. Still, the drawdown we have seen, although very uncomfortable, is nothing out of the ordinary for a Midterm year.
So, we have been here before and have some history to guide us. What did the stock market do next on average? Since 1930, the S&P has averaged a 47.14% return from the Midterm bottom to the highs of the following year (Pre-Election Year). Often referred to as a “stock pickers paradise,” the Midterm bottom historically presented the best investment entry point of the four-year Presidential Cycle. Although history may not always repeat, it often rhymes very well. And since 23 out of 23 Midterm “bottoms” have produced very generous positive returns soon thereafter… shouldn’t we be optimistic?
Also, if you look at Midterm bottom data for the Nasdaq Composite, which is the worst-performing market area this year, the average gains are even better. Data for the Nasdaq only goes back to 1974 and shows that, on average, the index will bottom out after losing roughly -17% from the previous year’s close. The rewards for the Nasdaq are much greater coming out of the Midterm bottom, as the index on average returns 70.32% into its Pre-Election highs.
This year has been especially challenging for the Nasdaq Composite, and it is currently about 10% off its traditional loss levels for a Midterm year. Perhaps this will only provide a greater force when a rebound occurs, like a fully stretched rubber band.
The chart below offers a good illustration of the Presidential Cycle's pattern.
From the November 2020 election, the pattern would have expected the S&P to peak in late April before trading down into the Midterm bottom in late September or early October.
Through 2021, the correlation between the S&P 500 and the Presidential Cycle was pretty good, and one could argue the S&P was even more substantial than expected due to fiscal and monetary stimulus. In 2022, the correlation has not worked out as well. We can assume that comments and actions by the Fed, Ukraine, and hyperinflation have all pulled forward the expected summer correction a bit earlier, similar to the May Break of 1962 and the Tech Crash of 1970.
While the history of the Midterm bottom provides us with positive expectations over the long term, we can use the short-term fundamental data of the market to offer us expectations of what we could see moving forward. By Friday, roughly 90% of the S&P 500 has announced earnings for the first quarter of 2022. Out of the 458 companies, earnings have risen +9.2% from a year ago, while revenues have risen almost 13%. A much more solid quarter than expected or what the market is pricing in at this time.
We bring up these numbers because if we are headed into a recession, as the financial media seems to be trying to talk us into, it would be the first time since 1987 that we would have fallen into a P/E led bear market/recession while earnings continued to increase. Between August and December of 1987, we saw a massive drop in the S&P of 33.5%, most of that damage occurring on Black Monday. The bear market of 1987 lasted 101 calendar days. Over that time, we saw the forward S&P P/E ratio fall from 14.8% to 10.5% and saw earnings rise by 6.3%. If the current correction turns into a bear market, it could be short-lived, just like what we saw in 1987. The market fundamentals that we monitor each week show forward earnings, revenues, and profit margins in solid uptrends and rising into record territory. At the same time, the S&P forward P/E has compressed by close to 2%.
These types of markets are never easy as they regularly test investors' emotions. And while things may feel hopeless at times, remember that market history, especially in Midterm years, shows that there are likely much better days ahead, possibly sooner than later. Also, while there are a lot of experts out there that keep saying, “this time is different,” remember the market is a one-act play; it tends to repeat itself; it's just the players that are different.