​As Sam Sees It: Why the Market Shouldn’t Hope for a Gridlocked Government

Sam Stovall  |

Each week, we tap the insight of Sam Stovall, Chief Investment Strategist, CFRA, for his perspective on the current market.

EQ: Investors had high hopes entering the first quarter earnings reporting period. It’s still very early, but there have been some pleasant surprises for the bulls so far. What are your thoughts on what we’ve seen thus far in terms of earnings and guidance?

Stovall: I think both earnings and guidance have been very favorable for equity prices. First quarter earnings estimates were previously expected to be up 16.7% for the S&P 500. Now, the projection is for 17% growth. The unlikeliest of leaders is Utilities, where their earnings forecast is higher by almost 14% from where it was originally.

We also saw a bump up in Health Care and Financials, as well as some early weakness coming from Consumer Staples, Tech and Materials. But for the full year, it now appears as if we’re going to see an 18.7% gain for the S&P 500, a 30.4% gain for the SmallCap 600, and each one of the 11 sectors in the S&P 500 are expected to post positive earnings changes year-on-year, with nine expected to post double-digit earnings gains.

EQ: Earnings were viewed as a catalyst for the market heading into this reporting season, and it looks as though the early results are delivering on that. However, one potential red flag investors are growing concerned about is the narrowing yield spread between the two-year and 10-year Treasury bonds. This is one of the key indicators that a recession may be on the horizon. Has this affected your outlook on the market for the intermediate or long term?

Stovall: Maybe for the longer term, but not necessarily for the intermediate term. Yes, the flattening yield curve is something to watch, but we’re still positively sloped. Historically, we have needed to see a yield curve be inverted by 60 basis points before a recession kicks in. So, usually there is a big lead time between the flattening of the curve and when we actually fall into either recession or a bear market. It is something to watch, but it isn’t something to be immediately worried about.

EQ: In this week’s Sector Watch report, you looked ahead at the upcoming midterm elections, and the potential implications it may have on the market from a historical perspective. More specifically, you debunked the myth that a gridlocked government is good for the market. Is this really the case?

Stovall: What I found was that the best market scenario was when we had a unified government—meaning that both the President and both Houses of Congress were from the same party. Instead of getting an average 8.8% return, we got an 11.2% gain in this scenario. So, it’s not surprising that when you have all the areas of government controlled by one party that you do end up getting a bit more rubberstamping, and therefore, more economic stimulus.

A split Congress scenario has usually been the worst performer on a price-change basis, up only 6.9%, but there are two things to be aware of. First is we’ve only had 12 years where we’ve had split Congresses, and the market actually did very well under President Obama’s four years in which he had a split Congress, primarily because we were coming out of the deepest bear market since World War II.

Yet, in the eight years under Republican presidencies where we had split Congresses, we saw the weakest returns of any scenario, with a gain of only 3.5%. I think what it implies is that, yes, from a cynic’s perspective it is good to get government out of the way, so they don’t mess things up. At the same time, however, you get very little guidance on the national level, so investors have no stimulus to look forward to. They then are focusing primarily on organic growth of the economy and therefore earnings.

EQ: If the best performance was a unified government, where did that myth come from?

Stovall: I think it could come from a more cynical perspective, because there is an old saying that goes, if the opposite of “pro” is “con,” then the opposite of “progress” is “Congress.” So, if investors take that one step further and say, “Well, if Congress can’t agree to do anything in order to add to our regulatory burdens, then that’s good.” That certainly would be the case, but I think more times than not, Congress’ free-spending ways ends up stimulating the economy, which offsets any increases in regulation there could be.

EQ: Looking ahead to this upcoming midterm election, the market could be looking at potentially going from the best scenario of a unified Republican government to the worst scenario of a split Congress under a Republican presidency. Currently, projections show that Democrats have a good chance of taking control of the House of Representatives. What could a split Congress potentially mean for this market in terms of the catalysts that have been driving it so far?

Stovall: What I think it means is that, instead of the 19.4% price appreciation that we saw last year when we saw a Republican president and both Houses of Congress controlled by the Republicans, we’ll possibly have gridlock in 2019. So, maybe we end up with a mid-to-low single-digit price appreciation. The market does rise 3.5% on average and has risen 63% of the time whenever we’ve had a Republican president and a split Congress.

That’s a great guide, but obviously, it’s never gospel. Also, knowing that we are likely to be in the longest bull market since WWII by that time, chances are the market will be getting tired, and advances will likely be more moderate than explosive.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer


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