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: As we enter the final stretch of 2012, a lot of investors are already looking ahead to 2013. You noted in this week’s Sector Watch report that there are some major headwinds facing the U.S. economy that could impact the market’s performance next year. What are those challenges?
Stovall: Well, I think basically there are four issues serving as headwinds as we head into 2013. First, we’ll be entering the first year of a president’s term in office, which is traditionally the weakest of the four years. That is true whether you look to S&P 500’s share price performance, year-over-year percent increases in U.S. GDP, or to earnings growth, all going back to 1948. Second, come this January, the recovery that started in June 2009 will be older than the average duration of all recoveries since 1900. Third, the S&P 500 recorded a median 9-percent decline in price whenever the first year of the four-year presidential cycle coincided with a recovery that was older than 20 months. Finally, there’s just an awful lot of dire rhetoric surrounding the fiscal cliff negotiations that have continued to put pressure on investor confidence and also caused business leaders to sit on their hands to delay making decisions such as hirings and expansion. Even though we are getting a traditional end-of-year rally, some people are worried that we could be facing stiffer headwinds as we head into the new year.
EQ: In regards to performance during a president’s first year in a new term, does it matter whether it is a first term or second term?
Stovall: The decline of 9 percent looks at all terms, whether it’s first or second—or in the case of Franklin D. Roosevelt, third or fourth terms. What I found was that in a much smaller set of observations that only included the second term, there was still a decline but it was closer to 5 percent rather than 9 percent.
EQ: In January, when President Obama is sworn into his second term, it will mark the 42nd month of the current recovery. Why is an extended expansion period a negative?
Stovall: The reason why the maturity of an economic expansion plays into the potential weakness of the first year of a president’s term in office is that if the country is suffering from some ills that the president wants to cure, they will do so early in the new term. The reason is that it gives time for the economy to recuperate or give time for voters to forget about the failed policies. So this time around, I equate the U.S. economy to a very low-flying airplane that is vulnerable to unexpected downdrafts. The concern is that because of the age of this economic expansion, even heading into the first year, if we embrace austerity too tightly and raise taxes too dramatically, that could have a negative impact on the trajectory of this economy.
EQ: Despite those headwinds, S&P believes that we’re actually entering a secular bull market. Why is that?
Stovall: S&P’s Chief Technician Mark Arbeter believes that we are entering a new secular bull market. He points to several factors. First, usually at the peak of a secular bull market, investor optimism is at bullish extremes whereas at the end of secular bear markets, the sentiment is at bearish extremes. Sentiment has been quite low over the last several years.
Second, as a result of this low sentiment, investors have moved out of equities and into the more defensive areas such as treasuries. Now with bond prices possibly facing their own bubble, this looks again like investors have gone too far to one side of the ship. Because of that, valuations are very low as compared to historical levels whether you look to trailing PE ratios or projected PE ratios on both an operating and a GAAP (as reported) basis. Also, as he points out, we’re starting to see some bullish underlying technical patterns as well as leadership by mid-cap and small-cap stocks. From a fundamental perspective, usually prices lead fundamentals, so when trying to figure out if we’re beginning a new secular bull market, one typically does look at technicals over fundamentals. However, I would tend to say that with valuations right now point to an advance of anywhere from 10 percent to 20 percent over the coming year. That could bolster our technician’s case that maybe we’re beginning to enter a new secular bull market.
EQ: In terms of historical performance, how important is it for the market to get a Santa rally in the coming weeks?
Stovall: It is relatively important. First off, whether you go back to 1990, 1970, 1945, 1929, 1900, December has posted the highest frequency of advance as compared to any other month in the calendar year. Also, the average price change has been greatest for December. That may be simply because of the spirit of the gift-giving season, the optimism of investors who are focusing on five quarters down the road in terms of earnings as compared with one quarter, but usually investors are a bit more optimistic. That’s probably another reason why during election years, almost 40 percent of the election-year highs occur in December going back to 1900. Of course, past performance is no guarantee of future results but if we were to get a down performance in December, that is not a good sign, particularly since the full-year will have been up.
Since 1900, whenever we were up for the full year but ended on a sour note, meaning that December’s price change was negative, the median price change in the subsequent year was a decline of 6.2 percent, and the market fell more frequently than it rose. This has occurred 17 times since 1900. In every other scenario—meaning an up year and an up December, or a down year with an either up or down December—the median price performances were positive and the frequencies of advance were greater than two out of every three years. So only in this scenario, in which we have an up year and a down end to that year, could that end up pointing to some pitfalls in the coming 12 months.
