Indicator of the Week: What's In Store for the Second Half of 2016?

What can stock traders expect during the second half of this election year?

by Rocky White

Published on Jul 6, 2016 at 6:30 AM
Updated on Jul 6, 2016 at 6:30 AM

What's in store for the second half of 2016? This week, I'm going to look at how the S&P 500 Index (SPX) has performed in the second half of the year, depending on first-half performance, the presidential election cycle, and sentiment in the Investors Intelligence (II) poll.

First, though, the table below shows how the SPX has performed the second half of the year over the past 50 years, sorted by its performance during the first half. The data suggests that performance in the first six months can be a decent indicator for performance in the subsequent six months.
  
                      
Chart 1 2 half returns by first half

When the SPX lost a significant amount (at least 4%), the second half was positive only 38.5% of the time, usually averaging a slight loss. When the SPX was up 4% or more (the last two columns in the chart), then the index averaged a gain of over 5% for the rest of the year, being positive 75% of the time. 

In the first half of 2016, the SPX gained a paltry 2.7%. In years like this year, when stocks have been relatively flat (see bold column below), the index has had a positive -- but underperforming -- average return, with 67% of the returns being positive.    

Election-Cycle Years:
This is the fourth year of the presidential cycle, which means it is an election year. Going back to 1949, the table below summarizes the second-half performance of the S&P 500, depending on the election-cycle year.

The average return is the lowest for the fourth year, but I would say a 3% return in six months is nothing to agonize about. Interestingly, in the fourth year of the cycle, more than 80% of the returns have been positive, which is the highest of the four cycles. The average return may be underwhelming, but the consistency of gains is comforting. 

                               Chart 2 2 half returns by presidential cycle year

I was especially curious about the volatility in the second half of election years when compared to other years. You might expect elevated volatility in the fourth year of the cycle due to the uncertainty associated with elections. However, the standard deviation of fourth-year returns (10.5%) is right in line with the average standard deviation of any year since 1949.

It's a bit worrying, though, when you look at the average positive and average negative returns. The average gain during election years is lower than any of the other cycle years, indicating upside volatility has been muted. The average loss in the fourth year is highest in magnitude, so you tend to get quite a bit of volatility on the downside. In other words, the fourth year of the cycle typically gives an investor a positive, but small, gain on his money. In the relatively rare instance that stocks fall, they fall a lot. 

Investors Intelligence Survey: Investors Intelligence (II) collects the opinions of published advisors on a weekly basis, and determines the percentage of them that are bullish, bearish, or expecting a correction. This poll is often used to gauge investor sentiment. As contrarians, we tend to believe the lower the reading is for the bulls, the more bullish implications there will be going forward. The table below justifies this belief.

I looked back over the past 50 years, and found the average bullish percentage in the first half of the year, followed by how the SPX performed in the second half. In the first half of 2016, the average II bullish sentiment percentage was 39%, which isn't very high. This isn't surprising, given the amount of volatility that was present in the first half of the year, especially in the first quarter. The most recent poll showed 41% of advisors were bullish, which is close to the average of the first half.

You can see in the table below that when the average percentage of II bulls in the first half is less than 40%, then the S&P 500 averages a 5.8% return in the second half of the year -- the highest of the three brackets. When there are so few bulls, there is a lot of upside volatility implied by the average positive return of 14%. This makes sense, since when investors are most bearish there is the greatest chance of a large sustained rally, as they all buy back into stocks. When the Investors Intelligence poll shows the most optimism in the first half of the year, then the second half tends to underperform. When the average II bullish reading was above 50%, then the index averaged a slight loss of 0.80%, and was positive less than half the time.
                                          chart 3 2 half returns

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