Historical stock market cycles suggest a decent Santa Claus rally lies ahead

The S&P 500 index peaked in mid September at 1,474.51. Since then uncertainty over the outcome of the US presidential election and the resolution of the fiscal cliff has caused US stocks to drift lower. However historical stock market cycles suggest that this downtrend will soon reverse providing investors with a decent Santa Claus rally.

The S&P 500 index peaked at 1,474.51 on 14 September just 6.4% below the all-time high of 1,576.09 it reached on 11 October 2007. Since then the value of America’s top 500 publicly traded companies has drifted 3.9% lower to yesterday’s close of 1417.26.

An 18 month daily chart of the S&P 500 (Click on the chart for a larger version)

An 18 month daily chart of the S&P 500 (Click on the chart for a larger version)

Charts courtesy of stockcharts.com

As the chart above shows, the index remains above long-term support (blue line) which is currently around 1,400.

On a shorter-term chart the S&P looks to be forming a Falling Wedge pattern that could prove to be bullish if the index were able to break out to the upside on strong volume.

A 4 month 60 minute chart of the S&P 500 (Click on the chart for a larger version)

A 4 month 60 minute chart of the S&P 500 (Click on the chart for a larger version)

Charts courtesy of stockcharts.com

The recent weakness in US stocks can largely be attributed to investor uncertainty over the outcome of the US election and the upcoming Fiscal Cliff. In around 24 hours, however, one of these issues should (baring the need for a recount) be resolved, and historical stock market cycles suggest that over the next few weeks the S&P 500 could put on a decent Santa Claus rally.

The chart below shows the typical performance of the S&P 500 index in an election year (red line). The data stretches back to 1828 and the blue line shows the progress of the S&P 500 this year.

While not a perfect correlation we are clearly following the historical pattern and if it continues we can expect a decent year-end rally.

S&P 500 average annual return (%) 1928 to 2012

S&P 500 average annual return 1928 to 2012

Source: Bespoke Investment Group

The upward bias following the election result is almost certainly a result of the renewed optimism among investors, many of whom move their money out of bonds and other safe havens into equities.

History suggests that tomorrow’s election result will mark the start of a year-end rally in US stocks, however it’s possible that concerns over the upcoming fiscal cliff will continue to dampen investor enthusiasm.

As I have pointed out before, after the election a lame duck Congress has just 30 days to find a way to avert the fiscal cliff. The best estimates are that if these tax increases and spending cuts do come into effect on 1 January 2013 US GDP will fall by around 3 to 4% returning the US to recession.

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