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A map showing the makeup of the 116th U.S. Congress, which will convene Jan. 3, 2019. Image courtesy 270towin.com

CAPITAL IDEAS: Mid-term concern is so last week

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By Wednesday, Nov 28, 2018 Trade and Commerce

Dalton — Whoever said that the stock market’s struggles were because of midterm election uncertainty is only telling you a small part of the story. While America’s attention has been focused on election battlegrounds, the real fight for the stock market is the escalating trade war between the U.S. and China. If that isn’t figured out, we’ll get a recession and, subsequently, a bear stock market.

Tariffs and trade wars are bad for business. Locally, I recently visited a Berkshire-based manufacturing firm that ordered a new machine for its manufacturing facility and the price went up $85,000 due to the tariffs on Chinese goods. Businesses are feeling pain from the tariffs across the nation. Here are some comments I’ve heard:

“… shortages and much longer lead times …” – Computer & Electronic Products

“Tariffs are causing inflation …” – Chemical Products

“…pace has slowed since the first half of the year … backlog is declining … certainly trepidation about the future.” – Machinery

“… pricing pressure and longer lead times in most commodities.” – Primary Metals

“… supply chains stressed.” – Transportation Equipment

“Backlog for Q4 and next year are way down.” – Fabricated Metal Products

President Trump tweeted that he had a “very good conversation” with China’s President Xi Jinping, which made the markets a bit more hopeful about the outcome of their meeting in Buenos Aires. The other great concern for the stock market is monetary policy, and we’ll explore that more in later columns.

Berkshire Money Management recently sent a contingent to Washington, D.C. for the largest annual professional investor conference, Schwab Impact. Former Federal Reserve chair of the board of governors Janet Yellen was the keynote speaker. Yellen shared: “I’m worried we’re headed for an economy that may overheat … At this point, a couple more interest rate increases are necessary to stabilize growth at a sustainable pace and stabilize the labor market so it doesn’t overheat.”

You can see the yin and yang between the dangers of an international trade dispute and a U.S. economy so strong the Fed has its sights set to slow it down. Presidential tirades about the Fed moving too fast aside, the Fed is moving at a moderate pace. It’s moving about half the pace it did in 2005, when it raised the federal funds rate 0.25 percentage points at each meeting (which, by the way, was considered a measured and gradual pace at the time).  

Internal Memos

Once the U.S. stock market dips 10 percent, as it has, there is about a 1–4 chance that the decline continues and reaches 20 percent. The threat of a bear market is elevated.

Once you go past 5 percent, you typically go further, for an average drop of 12 percent over 40 trading sessions. The selloff through October saw the market drop 11 percent over 25 trading sessions. It was nearly textbook. Of course, that usually means it takes months to repair that damage, but it does looks as if the majority of the decline is behind us. We could go further. This decade, we had a decline of 21.6 percent and one for 15.2 percent. A decline of either of those magnitudes would be within the S&P 500’s trading channel over the last decade.

Other history is on our side, too. Not that history repeats, but it often rhymes. The S&P 500 has been up in the 12 months following every midterm election since the middle of the last century, with gains from 1.1 percent in the post-1986 vote stretch (which included the Oct. 19, 1987, crash) to 33.2 percent in the year after the 1954 election.

The span from the fourth quarter of the second year of an administration (now) through the first and second quarters of an election year (the first half of 2019) has been the best nine-month period for the Dow Jones Industrial Average in presidential cycles dating back to 1896. However, when the House majority flipped from one party to another, as it just did, the DJIA was up only an average of 1.9 percent a year after (vs. 16.8 percent when the majority party retained control). The evidence doesn’t point to better days ahead so much as it just delays the next stock market crash.

Nonetheless, a rally of the 5 percent magnitude wouldn’t be surprising over the next few months. At BMM, we’re contrarians—we become more bullish when others become more bearish. Currently, investors are about as bearish as they were prior to the last election, per the put/call ratio. The put/call ratio looks at the number of investors making bullish bets (by using puts) versus making bearish bets (by placing calls) as a means to protect portfolios. The ratio has gotten to a level where a contrarian rally looks likely into year’s end.

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Allen Harris’ forecasts and opinions are purely his own. None of the information presented here should be construed as individualized investment advice, an endorsement of Berkshire Money Management or a solicitation to become a client of Berkshire Money Management. He can be reached at aharris@berkshiremm.com or call (888) 232-6072.


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