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CAPITAL IDEAS: How risky is the stock market today?


Recently I attended the annual Schwab Impact conference. It’s one of—if not the—largest investor conferences. This was my 15th Impact in a row and probably my sixth or eighth conference of 2022; I lost track.

Throughout that decade-and-a-half, I’ve attended investor conferences through the Financial Crisis, the European debt crisis, taper tantrums, interest rate hikes, cryptocurrency crashes, earnings recessions, regular recessions, U.S. debt downgrades, commodity bubbles, commodity crashes, and more. I don’t recall being at another conference where professional investors were more concerned about the U.S. economy and the stock market than today. The contrarian in me loves that.

For all the talk of so-called “smart money” and “dumb money,” investors consistently revert to their human behaviors and act emotionally at extremes. They let fear and greed supersede rationality. Granted, you can never tell if something has reached an extreme without the benefit of hindsight. But there are some tools we can rely upon to get a historical sense. I often rely upon Investors Intelligence’s Advisor Sentiment to try and “profit from the madness of crowds.” (Side note: of all the investment subscriptions I use, not only is this one helpful, but it is one of the most reasonably priced out there at $345 per year. Not a bad deal compared to some of those day-trading subscriptions out there promising you big gains when, in fact, the outcome is “reliably negative returns.”)

Advisors’ Sentiment surveys the market views of investment newsletters. The findings are reported as the percentage of advisors who are bullish, bearish, or expect a correction. I usually jump right to the bull-bear spread. “Large negative differences [between bulls and bears] signal diminished risk and allow for accumulation [of stocks].” Currently, the bull-bear spread is -1.4 percent (more bears than bulls).

Chart courtesy of Investors Intelligence.

The peak bearishness for Advisors’ Sentiment this cycle was -19.1 percent in October 2022. That was its most bearish reading since coming out of the Financial Crisis in 2009.

The crowd is so pessimistic that some risks have been wrung from the market. As a former financial advisor for Berkshire Money Management (they make me do some other things around the office nowadays), many people ask me, “you must be good at math, huh?” I guess so. I mean, I know how to use a calculator. And I have, dare I say, an at-least-average grasp on statistical probabilities. But the more important thing about math in this business isn’t how to do the calculation but rather knowing what to measure. Regarding sentiment, the math tracks the Law of Supply and Demand.

When investors of the retail or professional variety are bearish, they sell. Stock prices capitulate as the supply of stocks available for sale swells. Eventually, everybody who wants to sell has sold, leaving only buyers. Then prices rise as they become inexpensive enough to attract buyers. The math from Advisors’ Sentiment makes me feel more constructive about the market’s prospects. Extreme negative sentiment is good news, but that’s just one data point helping us to determine how risky the stock market is. I can understand why people hate the market—the bad news sometimes feels overwhelming. Still, there are other pieces of fortuitous data, such as seasonal factors.

November and December have historically been the two best months of the calendar year for stock market indices. And the average six-month return after a mid-term election is 15.1 percent.

We’re also entering the best period of the four-year presidential election cycle. The middle part of year two of the Election Cycle (2022) has historically punched stock market investors in the face and knocked them to the canvas.

Chart courtesy of Bespoke.

After investors get their bells rung, they get up off the mat in the last two months of that year and the first half of year three (2023) to wrestle back their returns.

That’s the good news. The bad news is that the stock market, represented by the S&P 500, remains in a bear market trend. The market has been below its 200-day moving average for 152 trading days. It’s good to see investors throw in the towel because extreme bearishness sets up potentially higher prices. However, there is still nothing more bullish than actual higher prices.

And don’t get me started on the Federal Reserve bank strangling the U.S. economy. The Fed has raised its Federal Funds rate from a range of 0.00 percent  to 0.25 percent on March 17, 2022, to a range of 3.75 percent to 4.00 percent on November 3, 2022.

I’m not saying the Fed is doing the wrong thing; they must fight inflation with monetary tools because they’re getting no help from fiscal levers. But they are doing something with zero regard for stock investors; they are intentionally stalling the economy to the point of recession. Oh, they don’t say the “R” word—that would be a sort of political violation. But they do admit that the results of their rate hikes will cause “pain” to the economy.

Higher interest rates affect the economy with a lag, so the additional pain is yet to come. I know, I know. Since 1950, the stock market has historically peaked roughly six months before a recession; it bottomed about three months before the recession ended. But those are just averages. The average economist (myself excluded) thinks there has not been a recession so far in 2022. The average person (figuratively speaking) believes that the actual recession will begin in 2023. If that’s the case, then you tell me when that pre-recession rally starts. March 2023? June? OK, fine. That means stocks must fall again to ignite a rally. As the Fed stands on the throat of corporations and consumers, there could be space for additional equity sales as a bad economy overwhelms positive seasonal factors.

I am confident we’ll consider this period as an excellent buying opportunity two years from now. Stock valuations have come down considerably. Although corporate profits may not be expanding generously, they’re holding steady. But the next twelve months still have headwinds. Considering those headwinds, I bought more portfolio insurance for investment accounts with a conservative or moderate target.

I sold the iShares S&P 100 exchange-traded fund (symbol: OEF; an ETF that holds the largest U.S. corporations). I also sold Invesco S&P 500 Low Volatility ETF (symbol: SPLV; an ETF that holds the 100 least volatile constituents of the S&P 500 index). In addition, I sold some of their quasi-“equivalents” (for lack of a better vocabulary). With the proceeds, I bought the Innovator U.S. Equity Buffer ETF (symbol: BNOV).

BNOV is a defined outcome ETF with a 9 percent buffer. It protects you from the first 9 percent of a decline if the stock market drops between November 1, 2022, and November 1, 2023. At the same time, it still allows you a generous capped return of 28.68 percent, should the stock market have such a solid year.

Selling OEF is the continuation of selling the largest, growthiest stocks in my portfolios. The twist this time is that I’ve got my eye on buying more small-capitalization stocks. Maybe not today, but it’s on my radar.

Selling SPLV makes sense because it performed its job this year. The 9 percent buffer of BNOV protects the investor. The generous cap adds the possibility of that 28.68 percent return should the S&P 500 advance that much. If the market were to experience such huge gains, I suspect that SPLV would lag on the upside. Given how far the market has already fallen, I feel I traded better protection and upside with that switch.

The Stock Market Usually Rises After Midterm Elections. This Time Could Be Different.

Year-to-date, 2022 has been awful for the stock market. Far worse than most mid-term election years. Yet, the pattern has been consistent with a century of price movements. The months leading up to mid-term elections typically have been less than stellar for equity prices.

If you asked me where stock prices go from here based on the election’s outcome, I would tell you that I don’t have a clue. I don’t know which laws will pass. I don’t know if one set of ideologues will buy more than those on the other side of the aisle will sell. I don’t know if politicians will finally use fiscal policy to assist monetary policy to fight inflation. Forecasting the economy is challenging enough. I don’t know how to indicate if a politician will keep a promise. And I don’t know how to predict the emotional buying or selling of emotional investors reacting to their party of choice winning or losing.

What do I know? I know that after months of pain, the stock market has hit a sweet spot for gains. Since 1930, the S&P 500 has averaged a 6.3 percent gain for the three months following midterm elections, according to Dow Jones Market Data. The last time the S&P 500 was down six months after midterms was 1947. Since 1950, the stock market has been higher 18 out of 18 times after midterm elections for the following year. That compares to a positive return nearly 80 percent of the time in typical 12-month periods.

Chart courtesy of LPL Research.

The returns after mid-terms have been nearly identical under Democratic and Republican presidents.

Does this mean we can expect gains this time? If I had a dollar for every time someone said, “gridlock is good for stocks,” I wouldn’t have had to play Power Ball last week. But that’s not guaranteed. Of the 19 midterm elections since 1945, there were three others where Democrats had complete control but gave up at least the Senate or the House to Republicans. In 1994, the S&P 500 rallied more than 27 percent one year after the midterm elections! But following the 1946 and 2010 voting, one-year performance was barely positive (0.1 percent and 3.7 percent, respectively).

The headwinds for stocks are significant for the following year. In its fight against inflation, the Federal Reserve is working against investors. I believe stocks will rally, but I’ll have to examine the move to see if it’s sustainable.

Allen Harris is the owner of Berkshire Money Management in Dalton, Mass., managing more than $700 million of investments. Unless specifically identified as original research or data gathering, some or all of the data cited is attributable to third-party sources. Unless stated otherwise, any mention of specific securities or investments is for illustrative purposes only. Advisor’s clients may or may not hold the securities discussed in their portfolios. Advisor makes no representations that any of the securities discussed have been or will be profitable. Full disclosures here. Direct inquiries to Allen at AHarris@BerkshireMM.com.



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