The market has been dancing to the tune of political developments lately. The coronavirus stimulus negotiations are having a material impact on prices in the short term, and investors are clearly worried about the coming elections and what they could mean for the stock market going forward.
Politics is important. As citizens, we should always be mindful of what is going on in the political scenario and we should always try to make well-informed and conscious decisions when the time to vote comes.
As investors, however, we should rather focus on variables with a proven and measurable impact on markets, and this does not include political speculation.
As opposed to trying to predict the future evolution of prices, investors should rather focus on assessing the market environment and adapting to it. The statistical evidence shows that momentum is a pervasive phenomenon in the market, and the momentum indicators are currently bullish for stocks.
Speculation Can Be Hazardous To Your Wealth
It is not that political developments are irrelevant to the stock market, they do matter, and sometimes they matter a lot. However, history shows that trying to make investment decisions based on political considerations tends to backfire more often than not.
Let’s take a look at a few noteworthy examples. On March 6, 2009, the Wall Street Journal published an article on how Obama’s radicalism was killing the stock market. As it turns out, this was a spectacular buying opportunity in retrospect.
Before Trump won the election in 2016, investment banks were predicting a decline of 10% to 15% in case this happened. During the night when Trump won the election in 2016, the stock market futures were plunging. That same night The New York Times published the following paragraphs by Paul Krugman:
It really does now look like President Donald J. Trump, and markets are plunging. When might we expect them to recover?
Frankly, I find it hard to care much, even though this is my specialty. The disaster for America and the world has so many aspects that the economic ramifications are way down my list of things to fear.
Still, I guess people want an answer: If the question is when markets will recover, a first-pass answer is never.
The S&P 500 actually made a quick recovery, and it continued rising in the days after the election, and well into the following months too.
Political factors do have an impact on the stock market, but these factors don’t happen in isolation. Monetary policy, earnings, valuations, and many other things are also part of the equation, and they can have a larger impact than politics. The point is that you can’t predict the market based on political drivers alone.
What can be more extreme than the assassination of a U.S. President? This chart from Helene Meister shows what happened to the stock market when Kennedy was assassinated. Talk about political uncertainty and turbulent times. It can hardly get much worse than that. However, the market performed quite well through that terrible period.
Within a week, the market already had recovered all its losses. Even more important, President Lyndon Johnson asked Congress for a tax cut in January of 1964, and this triggered a massive rally in stocks over the ensuing months.
A presidential election always creates uncertainty, and there are many important things at stake in this election. However, uncertainty is already reflected in current market information and hence incorporated in prices.
The historical evidence shows that the market generally does well when the political uncertainty is lifted after the elections, and the first year of a new President tends to be bullish for stocks.
A particular reason for concern among investors is the possibility of higher corporate taxes if the Democrats win. All else the same, the market doesn’t like higher taxes, but it is never all else the same in real life. We also need to consider how other factors like fiscal spending, infrastructure, and international trade tariffs enter into the equation.
In the past, the market has been able to do well in years with tax increases. So, even if you are expecting a tax increase in the near term, this doesn’t mean that the market needs to necessarily decline in that particular period.
Looking At The Evidence
The evidence shows that both absolute and relative momentum have a positive impact on subsequent risk-adjusted returns. In simple terms, when prices are in an uptrend – absolute momentum – and outperforming other assets – relative momentum – they tend to continue rising and outperforming over the middle term.
One of the main strategies that I monitor to measure market trends is the Asset Class Rotation Strategy. This strategy rotates between 9 ETFs that represent some key asset classes.
- SPDR S&P 500 (SPY) for big stocks in the U.S.
- iShares Russell 2000 ETF (IWM) for small U.S. stocks
- iShares MSCI EAFE (EFA) for international stocks in developed markets
- iShares MSCI Emerging Markets (EEM) for international stocks in emerging markets.
- Invesco DB Commodity (DBC) for a basket of commodities
- SPDR Gold Trust (GLD) for gold
- Vanguard Real Estate (VNQ) for REITs
- iShares 20+ Year Treasury Bond ETF (TLT) for long-term Treasury bonds
- iShares 1-3 Year Treasury Bond ETF (SHY) for short-term Treasury bonds
In order to be eligible, an ETF has to be in an uptrend, meaning that the current market price is above the 10-month moving average. Among the ETFs that are in an uptrend, the strategy buys the top 3 the highest relative strength ranking. This ranking is calculated via returns and volatility numbers over 3 and 6 months for the ETFs under consideration.
In simple terms, the strategy buys only the asset classes that are in an uptrend. Among the asset classes that are in an uptrend, it looks for the ones with superior risk-adjusted performance in comparison to the others.
The portfolio is monthly rebalanced, and the benchmark is All-World 60-40 Benchmark (BNCH), which is a portfolio of global stocks and bonds holding 60% in stocks and 40% in bonds.
The charts below show the historical performance numbers for the ACR Strategy since January of 2007. The cumulative return is 456.6% for the strategy versus 124.5% for the benchmark in the same period.
Such as important, the maximum drawdown, meaning maximum decline from the peak, is much smaller at 14.4% for the ACR Strategy versus 35.4% for the benchmark.
The strategy does a sound job of benefitting from big trends over the long term, even if it can’t be expected to outperform in each and every year. The Asset Class Rotation Strategy buys strong assets and sells weak assets. When market trends are strong, either up or down, the strategy works well in terms of capturing those trends. Conversely, when trends are weak, the strategy will tend to get hurt by false signals.
Looking at some specific years, the strategy benefitted substantially from a boom in Treasuries and other safe-haven assets in 2008 as stocks collapsed. In 2017, when stocks surged, the strategy also delivered big gains by riding the bull market in equities.
Even in 2020 so far, the strategy was positioned for safety in March and then it gradually increased exposure to risky assets as market conditions improved over the following months. The 21.8% produced by the Asset Class Rotation Strategy year to date is more than solid for such a challenging and volatile year.
On the other hand, in years such as 2105 and 2018, when market trends were fluctuating and short-lived, the strategy produced mediocre returns. The strategy is designed to capitalize on performance trends, both absolute and relative for different asset classes. When these trends are weak, so are the returns from the strategy.
Those limitations being acknowledged, these strategies don’t require any kind of forecast or speculation about the outcome of the elections and how this will affect the stock market. All that is required is reading the data and adapting to market conditions.
In order to put this kind of data to good use, you don’t necessarily need to buy the 3 ETFs recommended by the strategy. You can use the information to adjust your risk levels and your degree of exposure depending on how market conditions evolve.
As of the time of this writing, the strategy is positioned in Big US Stocks (NYSEARCA:SPY), Small US Stocks (NYSEARCA:IWM), and Emerging Markets Stocks (NYSEARCA:EEM). In other words, most stock indexes are in an uptrend and outperforming safe assets such as cash (NASDAQ:SHY), Treasuries (NASDAQ:TLT), and Gold (NYSEARCA:GLD) over the middle term.
As always, if the evidence changes, we need to be flexible enough to acknowledge this and change our minds. But it is what it is right now, and betting on the persistence of strong momentum in the stock market is a much sounder proposition than betting on a trend reversal because of the political noise affecting the market.
The Asset Class Rotation Strategy is updated weekly in The Data Driven Investor. A subscription to The Data Driven Investor provides you with solid strategies to analyze the market environment, control portfolio risk, and select the best stocks and ETFs based on quantitative factors. Our portfolios have outperformed the market by a considerable margin over time, and they are built on the basis of solid quantitative research and statistical evidence. Click here to get your free trial now, you have nothing to lose and a lot to win!
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.