The Election Cycle – What to Expect in Stocks & Bond Prices

Courtesy of Chris Vermeulen

It is that time in the presidential cycle that gets everyone emotional and concerned with the future outlook of the United States. While everyone has their opinion on whom, if anyone, is best for America, I promised myself a long time ago to keep my thoughts to myself for two reasons. ONE: only 50% of Americans will agree with me; and TWO: I am Canadian so I do not experience daily American life.

My thinking is that if Obama wins, then Quantitative Easing (QE) will continue unchecked. And with the recent positive economic numbers on Friday, it should give confidence to investors that things are SLOWLY stabilizing. Quantitative easing weakens the US dollar and is bullish for stocks.

If Romney wins, QE could be cut or eliminated, which is bad for equities.

I'll demonstrate how I think things will unfold in the next few days to months using charts.

The seasonal chart of the four year election cycle shows what the Dow Jones Index has done in past election periods. Every market environment is drastically different in each situation, but overall we see stronger stock prices. This is naturally an emotional time for investors, but once the election is finished, most individuals realize there is little they can do about it and the campaigning and debating is over.

DIA – Dow Jones Industrial Average – Daily Chart

Looking at the chart of Dow DIA Index fund you can see a 5-6 month cycle in the market which has a positive skew. A positive skew is when the market is trending up making a series of higher highs and higher lows. During a bull market, each cycle upswing lasts longer then when the cycle turns down. So there are longer rallies which send our secondary indicators (stochastics, volatility, put/call ratios, advance decline line etc…)  into the overbought levels for extended periods of time. Those trying to pick a top continually get their head handed to them. The focus must be on buying the pullbacks. Volatility tends to be higher. In the long run, we stand a better chance of making money trading with the trend than trying counter trend trades (picking a top).

The chart below suggests that stocks will be trying to put in the bottom over the next week or two, which falls in line with our election cycle. During intermediate cycle lows, some of the biggest drops take place. These sharp drops are needed to cleanse the market and shake out traders with tight stops before reversing and starting the next rally. I would like to see a 1-3 day market selloff as that would be the signature bottoming pattern on the way to a good buy signal.

Bond Prices – Moving Against the Norm…

Bond investors are some of the most conservative people in the market. They do not like to take risks so they dump their money into bonds to make a tiny profit in exchange for low risk (volatility). These investors put more money into bonds as we enter the election because they are nervous about who will be in control of the country. After an election is finished, some money may flow out of bonds and into stocks.

If Obama wins, I expect more of the same, QE holding up bond prices (with yields depressed), the Dollar weak, and equities strong. On the other hand, if Romney wins, there may be a threat to continued QE, resulting in a stronger Dollar and lower equity prices. This should not hurt bond prices, as investors will move out of stocks and into lower risk bonds.

TLT Bond Exchange Traded Fund – Daily Chart

Here is a chart of 20+ year bonds showing a possible reversal to the upside that could trigger as soon as next week. This chart is forward looking 1 – 2 weeks. Overall the trend remains down but if Romney wins, I feel bonds breakout above the red resistance levels and trigger a new uptrend.

Election Year Trading Cycle Conclusion

Next week is going to be very interesting to watch unfold. I generally do not like to trade or invest before high-impact news, as the subsequent price action could be wild.

This article is adapted from Chris Vermeulen's recent article for the Market Shadows newsletter, Vanity of Vanities (11/5).  For more by Chris, follow his Daily Trading Analysis & Trade Setups at: www.TheGoldAndOilGuy.com.

See also Dr. Paul Price's article QE3 Is Stealing Your Money. In it, he explains in numerical detail how QE reduces the value of the Dollar, similarly to how stock dividends work to dilute ownership. Only with QE, we don't get new shares in the Dollar to compensate for the diluted value of the old shares.

The term "quantitative easing" has a pedantic ring to it. Few people who are not economists have any idea what it really represents.  Keep reading >