'Tis the season to be bullish

Seeking the market's 'sweet spot'
Seeking market's 'sweet spot'   

Despite a heady run into November, stocks, particularly the lagging small caps, could be riding a tail wind into the year-end and possibly beyond, according to some strategists.

"It's headed pretty decently higher. The fact we were able to continue on and make new highs, not just in the S&P, but if you look at Japan, and European equities are having a decent bounce," said MacNeil Curry, global head of technical strategy at Bank of America Merrill Lynch.

Curry said even though the stock market is hitting new highs, the momentum and market breadth are positives that could keep equities moving higher. The S&P 500 and Dow were both slightly lower Monday, after closing at all-time highs Friday. A late-day decline in crude oil weighed on stocks and took West Texas Intermediate to $78.78 per barrel, a 2½-year low.

Traders work the floor of the New York Stock Exchange.
Getty Images
Traders work the floor of the New York Stock Exchange.

Some analysts say even laggard small caps should get a boost, and the small-cap Russell 2000 has outperformed over the last five sessions, up 4.7 percent, compared with the 2.8 percent gain in the S&P 500. "It's November, December, January, the best three consecutive months for the market, and within those special three months, you tend to get small-cap outperformance in November and December," he said.

Based on historic data going back to 1928, stocks are entering the typically best three-month period for equities of the year.

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"For the three months ending in January, the average return for the S&P 500 is 3.4 percent. The next best is June, July, August at 3.08 percent," said Paul Hickey, co-founder of Bespoke.

Bespoke also points out that November doesn't always start out strong, with the S&P down an average 0.8 percent in the first half of the month over the last 10 years, and in three of the past four years November's been negative.

Looking back to 1950, however, November has historically been the second-best month for stocks, with an average S&P 500 gain of 1.5 percent. Only December has been better with a 1.7 percent average gain since 1950.

UBS strategist Julian Emanuel agrees the next couple of months could be a good time for the market. "Our call has been that even if you did borrow a little too much (market performance) in the last two weeks from what we expect in November, December and January, we think that small caps in particular are going to work very well over that time frame, just because their seasonality is so pronounced," he said.

Beyond the normal seasonality, strategists say years in which there are midterm elections, the market tends to do better, and odds are good that stocks will be higher Election Day and the following days.

The midterm election takes place Tuesday, and political strategists say there is a good chance the Republican Party could take enough Senate seats to control both houses. That is seen as a positive for the energy and defense sectors.

Also Tuesday, there is a wave of earnings news including the first earnings report from newly public Chinese Internet retailer, Alibaba. Archer Daniels Midland, Burger King, Discovery Communications, Michael Kors, TransCanada, Valero Energy and Intercontinental Exchange report before the opening bell. Activision Blizzard, 21st Century Fox, Devon Energy, Liberty Media, FireEye, Zuklily and Papa John's report after the close.

There are also international trade data at 8:30 a.m. ET and factory orders, at 10 a.m.

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Maxim Group technical strategist Paul LaRosa remains unconvinced the market will keep stepping higher without selling off first. He believes the small caps will fail to confirm the higher trend, bringing the rest of the market down with them.

He said the S&P 500 needs to confirm its intraday high, closing above 2,019, while the Dow and Nasdaq have already broken into new ground. The S&P was at 2,017 Monday, off a fraction of a point. The Dow was off 24 at 17,366.

LaRosa said the Russell would have to confirm its old high of 1,213. "I think we'll go lower first," he said. "I think it will be a negative divergence, and I think we'll have a selloff before we have another rally, and then we'll have to see how it goes."

The Russell's divergence ahead of the mid-September selloff was a red flag for the market. The small-cap index is up just 1 percent for the year, compared with the 9.3 percent gain for the S&P.

But Emanuel says a move higher looks to be clearly in the cards. "This 'V' shaped bottom we've had is declaring 'V' for victory over a lot of things—growth concerns in Europe, public health concerns and concerns the Fed is moving to raise rates, perhaps faster than expectations," he said.

Strategists say in midterm election years, stocks tend to get bumped around ahead of the election on the uncertainty, but then take off after the election.

Samuel Stovall, equity strategist at S&P Capital IQ, said that both houses of Congress have been controlled by the same party in 110 of 114 years and in those years, the market tends to be higher.

"Even better, investors may have forgotten that the combination of a Democratic president and a unified Republican Congress has been accompanied by the best average performance for the S&P 500 since 1945, as the S&P 500 rose an average 15.1 percent in the eight times since 1945 in which a Democratic President has been opposed by a Republican-controlled Congress," wrote Stovall, in a note.

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Still, the midterm election itself has been a bullish period. Stock Trader's Almanac Editor Jeff Hirsch says there are data going back to 1934, that shows the Dow down only four times between Election Day and year-end in the 20 midterm election years.

"It seems the Republicans are going to take the Senate as well. You haven't had a situation where you had Republicans in the House, a Democratic president and then the Republicans take control of the Senate," said Hickey, pointing to data going back to 1960. "When you look at periods where you had a Democrat as the president and Republicans in Congress, it was a positive period for the market. It's the old gridlock is good cliché."

Stocks bounce into November
Stocks bounce into November   

But Emanuel points out that in 1994, when Republicans swept Congress and Bill Clinton was in the White House, the post-election performance was rocky.

"If you look at the last time, 1994, you basically had a sort of sloppy market in November and December before embarking on one of the greatest rallies of all time in 1995," he said. In November 1994, the S&P lost 4 percent.

However, Hirsch says besides the normal seasonality, the market is entering an even longer period that is traditionally positive for stocks.

"The 'sweet spot' is in the fourth quarter of the midterm year, and through the second quarter of the pre-election year. Going back to 1949, the Dow Jones was up an average 21.5 percent from Sept. 30 through June 30," Hirsch said. He said the S&P was up an average 22.2 percent in the same three-month period since 1949.

"The pre-election year has been huge. That's a 17 percent gain on average. I don't think we're going to get all of that in 2015. I think we paid it forward a little here," he said. As for statistics on the pre-presidential years for second-term presidents, there is less to go on. There have only been six, and those years were weaker on average.

Despite the seasonal factors, LaRosa says the market will continue to take its lead from small caps. "This rally has taken people by surprise," he said, adding investors now have a chance to reposition. "I think that would be a way to play this. Until the Russell is in line with the other indexes, you have to be a little cautious."