GDP + Elections Produce an Anxious Stock Market

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Investors, from big pension funds to IRA and 401K owners, look confused, which tells me that it’s either data (and data extrapolation) overload or we may be at an inflection point in the stock market. You might not think there’s anything unusual going on because we’ve had the best October performance from stocks in several years (September wasn’t too shabby either,)  and we keep getting blown away by outsized earnings gains from big U.S. companies. The latest hyper-growth example comes from Microsoft, which reported on Thursday that  the popularity of Windows 7  helped boost 3rd quarter earnings by 51%. The economic numbers are also mildly encouraging. On Friday morning the Commerce Department reported that gross domestic product grew at an annual rate of 2.0% in the third quarter, up from the 1.7% rate of the second quarter. Consumer spending picked up a bit; business spending remained weak. Not a bad report, overall.

Stocks, however, are stuck in place. The broad S&P 500 index has been hovering just below 1200 for a few weeks now. That 1200 represents a recent high water mark because that’s where the stock market climbed to in April before falling back. More importantly, notes Mary Ann Bartels, technical analyst at BofA Merrill Lynch, the 1200 mark represents the top of the trading range that has persisted since late 2009.

What does the stock market need to get through the psychological ceiling? A good shot of quantitative easing by the Federal Reserve will surely help. The third quarter GDP number reinforces this expectation for QE2 because the economy remains weak enough to keep the Fed on its toes. 

Therein lies at least one explanation for the stock market’s confusion. The weak economy (mildly bearish) will prompt the Fed to ease (mildly bullish.)  You might think that stocks would not get hung up on economic concerns because U.S. companies are reporting stellar profit growth. But earnings news is not lifting investor spirits the way it once did. Increasingly, positive earnings surprises are resulting in little or no added stock market gain for individual companies.  (Of course, blow away earnings reports like Microsoft’s are another matter.) What investors are most interested in lately are the larger issues. To wit, the Fed’s intentions and the mid-term elections.

 The election could lead to an extension of tax breaks and a role back of some regulatory reforms. Whatever your political views on these issues,  Mr. Market likes those possibilities. So if we get the Fed doing what it intends to do on QE2, and we get election results that signal a  slightly more conservative agenda, we may see the stock market break through the 1200 mark and keep on marching higher. In this regard, Bartels sees November as “a pivotal month” for stocks. Traditionally, she notes, mid-term elections translate into powerful 4th quarter gains for stocks, with an average rise of 6%.

But don’t hope for a Republican sweep. Back in 1994 (President Clinton’s midterm elections,) when the Republican tidal wave resulted in right wing control of the House and Senate, the stock market lost a bit of ground in 4th quarter, falling 0.74%.  It could even be worse this time around because there is a broad trading range that the market could head back into, with a lot of room on the downside.  If there a message here it’s that Mr Market wants less regulation but neither does it want a dysfunctional Washington.  Hope for moderation and an S&P that nudges through 1200.

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