Stock market is waiting to exhale after election

The performance by the equity markets in October was in line with expectations as the presidential election cycle made its presence felt.

Other factors were also in play including weak third-quarter earnings, deteriorating geopolitical conditions in the Middle East and an unprecedented storm that ravaged the East Coast.

The overriding factor, however, remains the election and the uncertainty surrounding the event. This is not easy to sort out given the history books suggest that stocks may rally regardless of the outcome of the election and do better if the incumbent wins.

In the present example, the threat of the fiscal cliff could upset this traditional pattern. The concern is that an incumbent win could mean the polarization of Washington becomes more deeply seated at a time when tough decisions are required. Therefore, our best guess is that should the President win re-election the immediate reaction by Wall Street would be a sell-off followed by an on again-off-again rally into late December that is hampered with tax-related selling. A win by the challenger is expected to offer a different blueprint, one that more closely follows the Reagan win in 1980. Stocks rallied from November to April following Carter’s defeat before running into problems later in 1981.

It’s the debt st—-
The history behind unusual weather events is that they do not have a significant influence on the equity markets. This is because such occurrences do not have a long-term impact on the overall economy. Thursday’s jobs data showed the labor markets firming. Initial unemployment claims were better than anticipated and the ADP number stronger than forecast. Expectations for Friday’s Labor Department report are that the economy created 125,000 new jobs in October, which is less than the ADP number of 158,000. The ISM Manufacturing Report this morning was slightly stronger than expected with the factory index climbing to 51.7 last month. That is an improvement over the September figure of 51.5, suggesting the manufacturing sector has stabilized.

Over the past six months the data has been split with the consumers opening their wallets while business has maintained a tight leash on expenses. The concern is that in the absence of wage growth, consumers have raided their savings to maintain a lifestyle. Ultimately, consumption follows that path of wages and salaries and is sustainable only when the savings rate is high. Debt levels also play an important role. As debt levels rise, servicing the debt saps the energy out of an economy and diverts capital away from investments that create jobs. As a result, a significant change in the tax code and a harness on government spending are critical to rebuilding the structural imbalances in the U.S. economy.

The weight of the evidence
The weight of the evidence is supportive of a year-end rally. Federal Reserve policy remains very friendly to the financial markets. Although the law of diminishing returns may eventual impact Bernanke’s strategy of inflating certain assets to boost overall economic activity, the near-term impact is positive. The economy remains fragile and suspect and we rate this as a negative but the economy is only one-sixth of the indicators and, therefore, does overrule a rally into late December.

The largest support comes from seasonal factors as the market enters the strongest six-month period from November 1 to April 30. The breadth of the market has deteriorated in recent weeks and improvement from this indicator is critical for the market’s performance in 2013. Although we rate investor sentiment as neutral, it is a vast improvement over the excessive optimism seen in September. Valuations are debatable but we feel stocks are fairly valued using price/earnings ratios and, therefore, not an important influence on stocks near and intermediate term.

Bottom Line: October weakness followed by November/December strength on target. We expect stocks to go quiet into Tuesday. Please consult with your financial professional before making any investment decisions.

Bruce Bittles is the chief investment strategist at Robert W. Baird & Co. Inc. This blog was posted at BizTimes.com with permission from Baird.

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