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  • Writer's pictureRobert Baharian

Inflation, US Mid-Terms, and Stocks

I didn't write a note last week. I almost felt like I couldn't keep up. There was so much going on. From inflation, to US mid-term elections, to stock market rallies. Here's my wrap up and thoughts.

1. Inflation

This is the boogeyman. Until now (well, maybe). US inflation peaked in June of 2022 at 9.06%. It's been on a downward trend since then. July - 8.52%, August - 8.26%, September - 8.20%, and the number that made the market cheer like Collingwood supporters during the Collingwood v Richmond 2018 preliminary final, October - 7.75%.

It's super hard for central banks right now. They have one blunt tool to get inflation under control. And the timing of it all, gee-whiz, record consumer savings and corporate cash and profits, a tight labour market and wage growth, geopolitics, and supply chain issues. What is really driving inflation? It's hard to pin point.

Deutsche Bank (DB) published a piece recently where they looked at what normally happens next when inflation hits 8% through history using 100 years of data. In the chart below, 0 represents when inflation hits 8%, the dark blue like is the median inflation rate surrounded by upper and lower range in light blue, followed by Bloomberg consensus.

History suggests it would be unusual to see inflation now fall back as quickly as consensus believes over the next 2 years. In fact, using data from the last 50 years (the fiat money era), DB's chart shows that current consensus forecasts would be in the most optimistic decile of observations over this period. With everything that has happened over the last 3 years, I'm not ruling anything out.

2. US Mid-term Elections

I've written on this recently. You can read it here.

I'll summarise. Taking a look back in history, here's the performance of the S&P 500 in the period following all Midterm Elections since WWII as well as the performance in the year following all election days (Tuesday after the first Monday of November) going back to the end of WWII (1945).

In the year after the 19 prior Midterm Elections since WWII, the S&P 500's average performance has been a gain of 14.4% (median: 12.95) with positive returns 100% of the time. As shown in the chart below, performance following Midterm years has been consistently better than the average one-year performance (+8.2% with gains 74% of the time) after all election days since WWII.

Source: Bespoke

Here's a great summary by DB. It shows the performance of the S&P 500 through the four year election cycle with Y1 Q1 referring to the inauguration quarter of the new President and midterms being Y2 Q4. As you can see, the three quarters from midterms onwards are historically amongst the strongest quarters however far you go back. Indeed since 1949 they ARE the strongest three.

Will history repeat itself? Sorry to leave you on cliff-hanger here, but who knows.

3. Stock Markey Rally

Inflation is running at 7.75%. That reading in and of itself is not good. The market however does not look at things in absoluate numbers, it's all relative. Relative to exepctations. And 7.75% relatively speaking is a damn good number. The stock market shifted into 6th gear - up 5.54% in one day for its 15th-best trading day since 1953 when the current 5-day trading week began. This was only the 18th time since the year 2000 the S&P 500 has been up 5% or more in a day. All I'm trying to say is that with was huge. In fact, the Nasdaq 100 was up 7.49% for it's 20th best trading day on record and it's 77th one-daty gain of more than 5%.

Thanks to Bespoke, below is a table highlighting all 5%+ up days for the S&P 500 since 1953. As shown, historically the S&P has averaged a decline of 0.77% on the day after 5%+ up days and a decline of 1.73% over the next week. Typically we see some downside mean reversion in the very near term after huge up days like this.

Looking out longer term, however, the index's average change over the next six months has been +10.37%, and its average change over the next year has been +27.95% with positive returns 20 out of 22 times - thats 90% of the time.

Source: Bespoke

History also tells us that these type of extreme one-day gains have historically come during volatile periods for the market that have often been at or near the end of downturns. So we're either still in a bear market with some downside, or this is it. Very decisive and very helpful, I know.

Whether we're out of the woods in terms of inflation or not doesn't matter. Because as soon as we are, there will be another forest we find ourselves in, confused, hungry, and scared. Play the long game. The odds are in your favour.

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