This week, the big news was the Democrats’ takeover of the House of Representatives and the subsequent large bounce back in the stock market. Put together, it sounds like I am implying a causal connection. I suppose I am—but not the obvious one.
So, what caused the bounce?
Put simply, the Democrats’ taking the House did not cause the bounce. The real cause was the end of the elections. Despite all the angst ahead of time and all the coverage and analysis, there were only two possible electoral outcomes. First, the Republicans could have retained control of all branches of government. Second (and what actually happened), the Democrats could have taken control of all or part of Congress, leaving us with a divided government.
Historically, both outcomes have been positive for markets. So, once the elections were over and the surrounding angst and uncertainty went away, markets started to react to the actual policy implications of a divided government. A divided government means that not much will get done, reducing uncertainty around policy—which business loves. For the next two years, companies can reasonably count on federal policies being largely constant, and they can plan accordingly. This is a big positive. The bounce after the earlier fear-driven pullback is a rational response to that reduction in uncertainty, not to the actual results of the election.
Are we out of the woods?
Unfortunately, probably not. I took the market risk levels up a notch in my Monthly Market Risk Update to reflect the fact that confidence has been damaged and that markets are likely to keep responding to that. With lower investor confidence, the impact of negative news is likely to remain strong. This week, for example, interest rates have ticked back up on the Fed’s continued assessment of the economy as strong, the tariff issue continues to make headlines, and Europe remains at risk. Where markets might have shrugged this news off earlier this year, they now appear to be reacting.
Markets are also taking note that some key sectors of the economy appear to be slowing. Housing has certainly turned, on rising housing costs and interest rates, while consumer spending appears to have moderated. This general slowing may mean market confidence will be slower to return than it has been.
The initial bounce after the elections was a good start, but it has not been followed by similar strength. This lack of continued strength suggests the bounce was just a reaction to the election results, rather than a collective return to a risk-on posture in the markets. The question over the next couple of weeks is whether there is anything that will act as a catalyst to take markets back up.
One possibility is a resumption of company stock buybacks. With earnings season winding down, companies (which stop buybacks around their earnings announcements) will now be free to start buying again. This could be a significant tailwind. Seasonal factors, which typically drive the market higher toward year-end, will also kick in. There is reason to believe we might see more strength in November and December than we saw in October.
What to watch for the rest of the year
With the signs of weakness we have seen recently, though, in both the economy and the financial markets, that positive scenario looks less likely than it did only a couple of weeks ago. A failure to rally into year-end will be a negative sign for 2019—and will be something to watch for during the rest of the year.
Authored by Brad McMillan, CFA®, CAIA, MAI, managing principal, chief investment officer, at Commonwealth Financial Network®.
© 2018 Commonwealth Financial Network®