Each week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.
EQ: The midterm election results are in and it looks like the Republicans now control both the Senate and House of Representatives of Congress. This is probably the best scenario that investors could have hoped for, right?
Stovall: Yes, because if you go back to World War II, the average calendar-year price change from December 31 to December 31 was a gain of more than 15% whenever we had a Democratic president and a Republican Congress. That was stronger than any other time. However, a fairly close second was when you had a totally unified government where both the president and Congress was Republican.
In that scenario, you had a just-slightly less attractive return on average. So what will happen this time? Who knows? History is a good guide, but never gospel. I think what the performances imply is that now with some sort of a conciliatory tone by President Obama, his legislation will probably have a greater likelihood of being passed by a unified Congress.
EQ: As you mentioned, the market’s performance under a Republican president tends to do very well when the government is unified. Interestingly enough, however, the performance under a Republican administration when the government is not unified may also suggest that maybe Republican presidents don’t really play well with others either. Why do those periods lag behind so much more than the others?
Stovall: Well, now in a sense, I would be playing politics if I tried to give a reason for the underperformance by Republican administrations. Republicans would claim that it’s because the economy was in such poor shape when it was finally handed over to them that, as a result, every Republican president since Warren G. Harding has experienced a recession within the first two years of taking office.
That’s why whether you look to unified governments, unified Congresses, or split Congresses since 1901, the performances favored Democratic presidents because they’re regarded as the tax-and-spend party, and if you spend then that increases economic activity, which tends to bolster earnings growth. So I’ll leave it up to the politicians to fight it out regarding the harm or good they do to the economy. I will simply report the data.
EQ: S&P Capital IQ recommends that investors lean toward the cyclical sectors during this period. Does this coincide with the best six months sector-rotation strategy?
Stovall: Yes. Historically, the November-through-April period, which is the flip side of the sell in May period, is what I call the Cyclical Six. That’s the six months of the year where the cyclical sectors tend to do the best.
Since 1990, a portfolio consisting of 25% exposure to Consumer Discretionary, Industrials, Materials, and Technology groups would have outperformed the S&P 500 by more than 300 basis points per year and would have beaten the market in three out of every four times. Those results are even more impressive following midterm election years, with the batting average being 100%.
Of course, there is no guarantee that it will work this time around, but I think that if the market usually does better in November through April than May through October, and you tend to want to be defensive during May through October, then you’d want to be cyclical when the market does its best from November through April.
EQ: For those investors that sold out of the stock market in May and went away, they would’ve missed out on the 7% move on the S&P 500—although the bottom of the pullback would’ve represented a 1% loss had the market not roared back in the last two weeks of October—but you noted in this week’s Sector Watch that the sector rotation strategy into Health Care and Consumer Discretionary did hold true this year. How did it perform?
Stovall: In my book, The Seven Rules of Wall Street, the rule of thumb is sell in May and go away. However, I like to advise investors to not go away entirely, but rather to gravitate toward the more defensive sectors of the market. The reason is because if the returns are typically challenging from May through October for the market as a whole, then you’re better off focusing on the areas where the demand for the products and services remain fairly static, such as Health Care and Consumer Staples.
So it’s interesting but a lot of investors were very quick to say that sell in May did not work this year. To that, I would say that it did work had you taken the sector advice by being 50% exposed to Consumer Staples and 50% Health Care. That strategy saw an advance of 10.8% this year from May through October, versus 7.1% for the S&P 500.
As a result, the sell in May technique did work quite nicely, provided that you gravitated toward the more defensive areas of the market instead of just going into cash.
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