Locally based CPA firm since 1956

Are we now entering the next bull market? The Nasdaq gained 11.48% over the past month, bringing its YTD loss to (26.3%). The S&P 500 gained 10% bringing its YTD return to (14.01%) and the Dow gained 7.97% bringing its YTD returns to (4.93%).

Last month we wrote, The correlation between stock market performance and midterm elections is well documented. In 17 of the 19 midterms since 1946, the market performed better in the six months following an election than it did in the six months leading up to it. However, this time we have different circumstances. I doubt we see increased government spending from a new Congress. The combination of high inflation, the war in Ukraine, and a lingering pandemic, especially in China, has already made this cycle unlike prior midterm years.

What if we don’t consider this as a mid-term election year? The S&P 500 has achieved an average annual total return of 14.8% in the calendar year after each of the 16 down years between 1946 and 2021. That result is 3.5% greater than the 75+ -year average annual return of 11.3% for the index in the years 1946 through June 13, 2022.

Now some real stuff: With results in from 97% of S&P companies for the third quarter, according to FactSet, it looks like corporate profits are up only 2% from a year ago. We would not be surprised at all if economy-wide corporate profits fell in Q3 and, given bottom-up earnings estimates so far, continue to decline in Q4.

The stock market depends on two important factors. Profits and interest rates. As the Federal Reserve has lifted short rates, the entire yield curve has risen, and higher interest rates have been a big drag on stocks. Now stocks look like they’ll also have to grapple with stagnant to declining earnings. Therefore, we think the recent rally does not signal the end of a bear market, just like the rally from mid-June through mid-August, which ended with the S&P 500 peaking just north of 4300. The lowest close so far this year is 3577. We think the market will test that low and likely go lower before the next recession is through. The only way the recent rally turns out to signal that the worst is behind us is if the US somehow avoids a recession.

But with monetary tightening avoiding a recession is unlikely. This is especially true when we add in the fact that much of the economy, especially in the goods sector, must get back toward normal after being artificially supported by trillions in temporary stimulus in 2020-21. Yes, some recent economic reports have been solid, including retail sales, manufacturing output, and new home sales. Meanwhile jobs have kept growing. But the link between tighter money and less economic growth is long and variable. Back in 2020-21 we consistently said that the bill for massive over-stimulus would eventually come due. We are now much closer to getting that bill. Don’t let the time lag, or the belief that the Fed can reverse course just in the nick of time, convince you it’s not coming at all.

Volatility is a trader’s best friend. Without it, profits are harder to come by. However, the stickier volatility remains, the more it erodes confidence and causes shifts in the market. What should you do about it? Be more selective. Close out speculative positions and reduce the size of your bets in any one area of the market and invest more broadly utilizing a combination of value and growth.

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Have a question? Let me know! Email me at kcompton@wcmtexas.com.