Politics and the Stock Market

08/17/2012 1:02 pm EST

Focus: MARKETS

John Person

Founder and President, John Person, Inc.

As Election Day approaches, are we likely to see this year's uptrend continue or reverse? Veteran trader John Person gives his take on the technical outlook for the next few months.

The overall equity markets, as measured by the S&P 500 using the exchange traded fund (SPY) as of the close on Wednesday (140.79), was up just over 12% on a year-to-date basis. SPY closed 2011 at 125.50.

So the question begs, will the presidential election year bring in more positive gains for the US stock market, or are we building a distribution top?
 
Here lie some interesting political and economic uncertainties. As time passes, the Federal Reserve might be less likely to rock the “voting” boat, so to speak, by injecting more liquidity to the banking system with any type of quantitative easing prior to the November elections.

The next two FOMC meetings are on September 12 and 13 and then October 23 and 24. If the Fed adds liquidity, this may bring a more favorable response to the markets—boosting prices further, as well as voter confidence in the economy.

Mitt Romney’s vice-presidential running mate, Rep. Paul Ryan, has been a vocal critic of Ben Bernanke. So if we see the polls uptick for a Romney victory, will the markets be disappointed that with a Romney win, perhaps we could see a change of guard at the Fed?

So let's turn to the technical picture to see if this rally is on strong footing. The chart below in Figure 1 is the S&P 500 futures, which account for all trading sessions. This eliminates the gaps that the cash open outcry SPY demonstrates.

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As point a clearly shows, prices are testing the yearly highs. The middle quadrant shows the comparative Advance-Decline ratio for the S&P (point b), which shows less stocks are participating in this rally than when we were at the yearly highs back in late March.

The bottom section shows the on-balance volume indicator (point c). It shows the health of the rally is on weak volume.

Now let’s turn to the technology sector, as measured by the Nasdaq-100, as shown in Figure 2:

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The highs for this index were also established in March as well (point a). The issue is that the amount of stocks within this index have also not participated in the rally, as measured by the comparative Advance-Decline ratio for the Nasdaq.

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As you can see on the chart (point c), we are well below that level. In fact, as the price has broken out above the July highs, the Advance-Decline ratio has not even broken out above those levels (point d).

Moreover, the overall health of the rally has been on diminishing volume, as measured by the on-balance volume indicator (point e). This reveals that unless more stocks move higher, and relatively quickly, it appears the markets are signaling weakness or concerns right now.

So let’s look at one more index, the Russell 2000, as the chart in Figure 3 shows:

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While this is the weakest link in the major stock market “chain,” so to speak—which you can see as the current price is well off its yearly highs (point a)—my big concern here is the rally this last month has been met with a decline in the comparative Advance-Decline ratio and on significantly lower volume.

In bull markets, many times we see money flowing into speculative stocks and small-cap names. Both the Nasdaq and the Russell 2000 reflect otherwise.

So the answer to the question, “Will the presidential election year bring in more positive gains for the US stock market, or are we building a distribution top?" depends on if we see more stocks in these specific indexes pick up with increased volume to illustrate stronger market participation. If we do not see momentum build, then the chances are for the overall markets to experience a pre-election correction.

There is one more issue that has me more skeptical that the overall stock market is capable of moving up prior to the elections. The Nasdaq Transportation average, as shown in Figure 4, is actually negative on the year.

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Point a on the chart shows the close of the index in 2011 and the current price using a weekly candle chart.

Personally, I would like to see a broader-based rally, including small cap stocks as well as transportation stocks, to demonstrate strength and confirm further gains in the market.

At this point, I am preparing for a likely correction in the stock market as we head into October.

John Person is a 32-year trading veteran and regular speaker at Traders' Expos. Tom Aspray will return from vacation in two weeks.

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