The US midterm elections are over and markets are relieved, judging by the S&P 500's 2.1 per cent gain last Wednesday – its biggest one-day post-midterm bounce since 1982. Multiple historical tidbits suggest stocks will continue to gain, says LPL Research. Most equity gains tend to happen late in the year during a midterm year, it notes. Since 1950, in midterm years, the S&P 500 has averaged year-end gains of more than 10 per cent from its October low.
The fourth quarter of a midterm year has historically been the best quarter of the four-year presidential cycle, while political gridlock is associated with the best returns under Republican presidents. Of course, the political landscape is only so important to financial markets, which are more interested in interest rates, bond yields and corporate earnings. Still, last week’s results were undoubtedly viewed as positive.
Firstly, nothing unexpected happened – markets expected Democrats would win the House of Representatives and Republicans the Senate. Secondly, markets would love if politicians came together to work out an ambitious infrastructure programme, something both parties have advocated. Thirdly, Donald Trump is not in a position to push through further fiscal stimulus, whether it be via unfunded tax cuts or via unfunded extra spending, thus reducing the pressure on the Federal Reserve to tighten an economy at risk of overheating.
Markets now perceive the Democrats as the fiscally responsible party, as evidenced by the reaction in bond markets – bond yields spiked during the brief period where it looked like Republicans might win the House of Representatives before quickly plunging after it became clear the Democrats would win after all. The relief was also evident by the reaction of the Vix, Wall Street’s fear index, which fell to its lowest level in a month as markets cheered the easing of political risk.
Is the correction over?
The question may seem strange, given the apocalyptic commentary doing the rounds barely a fortnight ago, but the market mood has brightened following a rapid 8 per cent rally that erased much of the October sell-off. Too much should not be made of the recent bounce. Firstly, markets were deeply oversold at the end of October, so it would have been odd if they didn’t rebound higher. Secondly, big counter-trend rallies are common during corrections and bear markets, so it’s premature to say the coast is clear.
Still, the rebound has been very impressive and Instinet strategist Frank Cappelleri notes that, even before last Wednesday’s post-election surge, the S&P 500 had enjoyed three consecutive days of 1 per cent gains – a pattern only been seen on three occasions since 2010 (in October 2011, February 2016 and June 2016), all of which coincided with market bottoms.
Bulls are right to be encouraged but V-shaped recoveries are uncommon and volatility typically persists for a while. “A straight shot back to the highs still seems unlikely,” says Cappelleri.
Hedge funds suffer worst month in seven years
Hedge funds didn’t do a good job of navigating October’s market volatility. Instead of insulating investors from the sell-off, the average hedge fund fell 3 per cent, suffered their worst month in seven years.
Only a quarter of hedge funds were positive for the month, according to Hedge Fund Research. Unsurprisingly, the worst returns were seen in tech-focused hedge funds.
Hedge fund managers may protest that they outperformed global equity markets, which suffered even steeper losses. Still, it’s a hollow boast. Hedge funds are down 1 per cent in 2018 and have badly underperformed a basic 60:40 stocks/bonds portfolio for a decade.
Lousy returns mean managers prefer to talk these days about managing risk rather than turbocharged returns. However, October’s dismal performance is further proof that investors should think twice before paying high fees for hedge fund mediocrity.
Insider sales can be a warning signal
Company directors buying shares has long been seen as bullish, but insider sales are seen as less informative. After all, an insider might sell shares because they need to fund a house purchase, or diversify their portfolio, or any number of reasons – right? That’s not the whole story, says Prof Peter Kelly from the University of Notre Dame.
Yes, there are countless innocent reasons why insiders might sell stock, but it’s important to know whether insiders are selling for a profit or a loss. When a stock is sold for a profit, its subsequent six-month return is nine basis points better than in all other months.
When the stock is sold for a loss, however, returns over the following six months are 188 basis points worse than normal months. Why? Research has long shown investors really, really dislike taking losses. Selling at a loss is "painful", says Kelly, an admission that you made a mistake. To do so, an insider "must have particularly negative information". The study can be viewed at https://goo.gl/3Cgqa2.