Midterm Stock Correction Bets Could Backfire [Rydex S&P Equal Weight ETF, PowerShares QQQ Trust, Series 1 (ETF)]

wall-street-etfChris Ciovacco: If you work on Wall Street or follow the markets closely, you have undoubtedly heard that “stocks typically correct in midterm election years”, which is a relevant and factual statement. Our purpose here is not to question the validity of anyone’s analysis, but rather to highlight the potential pitfalls in relying too heavily on statements like the one below:

Midterm election years are typically poor performers for most of the year until finding a bottom in the fall and beginning a rally which lasts well into the following pre-election year. The traditional approach to seasonality during a midterm election year shows the final high (prior to the long period of under-performance) in April.

Let’s assume we base our 2014 strategy on a correction starting in April and bottoming in the fall, which is what the midterm election year pattern calls for. Since we are in a bull market, it is logical to examine midterm years that occurred during bull markets. Going back 20 years, the years that fit that profile are 1982, 1986, 1990, 1994, 1998, and 2010.

1986 Did Not Get The Midterm Correction Memo

Can we find cases where investing based on the midterm correction theory backfired? Yes. Assume our strategy in 1986 was to (a) sell all our stocks on April 1, (b) move to a 100% short position on April 1, (c) wait for the “inevitable midterm” correction to (d) cover the short after stocks make a new low for the year in the fall, and (e) move back to a 100% long position in stocks. The chart of 1986 below highlights the risks of betting big solely based on the midterm correction theory.

Not only did the midterm strategy not work well in 1986, it also could have significantly impacted your returns in a negative manner in 1987.

If your strategy was to cover your short after stocks made a new low for the year in the fall, then you never would have covered the short in 1986.

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