Markets are facing the looming prospect of a fourth-quarter election upset
The following is a reprint of the market commentary from the January 2020 edition of The Option Advisor, published on December 27. For more information, or to subscribe to The Option Advisor -- featuring 10 new option trades each month -- visit our online store.
As we head toward 2020, the major market indexes are on pace to end 2019 on firmly positive footing. But as we look ahead to new year, for many investors one persistent question continues to nag: how long can we expect this bull market to last? The broad-market advance off the post-financial crisis lows of March 2009 has now stretched well beyond its first decade, and it's natural to wonder when that impressive rally might finally run out of steam.
Then again, it's entirely debatable whether or not we experienced an "official" bear market in the fourth quarter of 2018. The broad-based Nasdaq Composite (IXIC) certainly did, based on the 23.6% plunge from its September high close to its December low close. So did the Russell 2000 Index (RUT), for that matter; the small-cap index was gutted for a 27.2% close-to-close loss by the time the dust settled on that brutal Christmas Eve session.
When it comes to other equity benchmarks, though, there's a bit of a gray area. Going by its late-September high close to its Christmas Eve low close, the fourth-quarter decline in the widely followed S&P 500 Index (SPX) maxed out at 19.7% -- not quite crossing the 20% barrier that serves as the threshold into bear-market territory. Likewise, the Dow Jones Industrial Average (DJI) was down only 18.8% at its late-December low close.
But with both the Nasdaq and RUT barreling headlong into bear-market territory -- and for that matter, based on its intraday high and low, the S&P itself fell 20.2% from peak to valley -- there's a reasonable case to be made for this bull market being both extremely long in the tooth... and, by other measures, still a spring chicken.
In any case, don't be alarmed if the stock market starts off the year on tepid footing, relatively speaking. Over the past five years, January has delivered an average monthly return of 1.42%. And with only 60% positive returns, January is near the bottom of the pack for the "losing-est" month -- which suggests we're currently in a three-month stretch of the year that carries increased risk for negative S&P returns. (Data is current through Dec. 20, 2019.)
And then there's the looming fourth-quarter prospect of another massive election upset, like the ones in both the U.S. and Britain that rocked global markets in 2016. Unfortunately, per the table below, we're wrapping up the tail end of the most bullish year of the U.S. presidential cycle, which happens to be the third.
The fourth year of the cycle isn't exactly awful, though. The average return is a respectable 6.75%, in line with those of the first and second years, and the percentage of positive returns is genuinely impressive, at 82.40%... even though the average negative return is the steepest, at 17.20%, and the average positive return the smallest, at 11.89%. Volatility is likely to ramp up, as well; the standard deviation of returns for the fourth year of the cycle is 14.61%, compared to 11.01% in the third year.
Given the prospect of another bullish -- if potentially surprising and volatile -- year for stocks, there should be plenty of opportunities for traders to make money in the market. But given the simultaneous prospect of increased uncertainty heading into a major U.S. election that's looming large in the middle of the fourth quarter, we recommend that you limit your dollars at risk and maximize your ability to leverage continued upside by using calls and puts to play directional moves in stocks.