This second in our series of quarterly outlook articles looks at how the US stock market tends to behave at the current stage of the business cycle
Q2 saw US markets continuing the sideways trend that started back in February. Heading into the summer, which has historically been a volatile time for stock markets, we could see more swings within current trading ranges that could create swing trading opportunities for both sides.
Why have the markets gone sideways?
It’s not uncommon around the middle of economic cycles for markets to level off for a while. Stock markets have historically responded to two major drivers - corporate earnings expectations and liquidity - the amount of cheap money available for speculation.
In the initial recovery phase of an economic cycle, stock markets often roar ahead boosted by a combination of easy money from central bank stimulus and speculation of improved earnings. During this time, stock market valuations can become stretched as earnings speculation runs ahead of results.
Eventually, however, central banks need to end the liquidity party or risk creating asset bubbles. Reduced access to cheap money for speculation reduces demand for stocks, limiting their upside. At the same time, the improving economy that has prompted the central bank to reduce stimulus cushions the downside as valuation support improves.
These two forces push stock markets into a mid-cycle sideways trend that in the previous two cycles in the 1990s and 2000s lasted from six months to a year. The chart below shows what happened to the S&P 500 during the 1995-1995 mid-cycle pause.
This pause can be a confusing time for investors. Stock markets struggling to advance can lead to speculation that a peak is in and a bear market is possible but the underlying support as earnings start to catch up to stock prices short-circuits the impending doom.
For traders on shorter term horizons, particularly those willing to trade from both sides, the mid-cycle pause can create significant opportunities for swing trading as the risk that the market could break the channel and get away declines for a while.
Trading action in the S&P 500 so far this year suggests that we may have started into a mid-cycle pause in November (which incidentally coincided with the end of the Fed’s QE3 stimulus programme) or February. If we measure nine months from February or 12 months from November, it looks like we are about halfway through the current consolidation phase which could run through to October or November.
The chart above also shows that the underlying trend of higher lows has continued, creating an ascending triangle (a bullish continuation pattern). This indicates that despite the cries of doom from some quarters, downside for the current market appears contained to current channel lows.
The most interesting thing about this mid-cycle pause and the outlook for a choppy but sideways summer is that it aligns with historical seasonal patterns for US markets. Historically, stock markets have started the year off strong then seen monthly returns drop off and even go negative between May and October (hence the old saying “sell in May and go away”) and then finish the year strong.
So far in 2015, monthly performance has been mixed relative to historical averages. The year started off really poorly in January but this was offset by a big rebound in February. The market then declined in March, underperformed in April and rebounded in May.
Historically US stocks have declined in June, rebounded during the July earnings season and then declined from mid-August through mid-October. This type of back and forth trading action suggests that we could see significant trading swings in both directions through summer, with the potential for an end of year rally when seasonal and cycle trends align more favourably.