It’s been nothing short of a banner year for Wall Street and investors. From the closing bell on December 5, it is timeless Dow Jones Industrial Average (DJINDICES: ^DJI)benchmark S&P500 (SNPINDEX: ^GSPC)and growth-oriented Nasdaq Composite (NASDAQINDEX: ^IXIC) are up 19%, 27% and 31% respectively year to date.
The two-year bull market on Wall Street was fueled by a number of catalysts. For example, the artificial intelligence (AI) revolution could mean a leap forward in growth potential for businesses. Moreover, the bottom lines of Wall Street’s most influential companies have, for the most part, been better than expected.
But the latest catalyst for the stock market may be the most eyebrow-raising: newly elected President Donald Trump’s victory in November.
Trump’s return to the White House for a non-consecutive second term in January will most likely pave the way for looser banking regulations, more merger and acquisition activity and possibly a 29% corporate tax cut for domestic manufacturers. The former (and incoming) president’s proposals are undeniably investor-friendly.
Unfortunately, history offers an ominous warning for Wall Street and the stock market as Donald Trump prepares to take office in just over six weeks.
President Donald Trump delivers remarks at the Pentagon. Image source: Official White House photo by Tia Dufour.
Republican presidents and recessions go hand in hand
Let me preface the following discussion with an important caveat: There is no such thing as a guaranteed forecasting tool on Wall Street. While some events, statistics, and predictive data points have an uncanny history of accuracy, there is no concrete guarantee that anything will happen in the stock market.
That said, history shows one exceptionally strong correlation between Republican presidents in the White House and US recessions
Over the past 111 years, there have been ten Republicans in the Oval Office and nine Democrats. Four of the nine Democrats who hold America’s highest office did not anticipate a recession that started during their term of office (key phrase!). This figure makes the logical assumption that President Joe Biden will not see a recession declared in his final six weeks in office, which would make him the fourth Democratic president to avoid a recession.
On the other end of the spectrum, Republican presidents have experienced 13 recessions since 1913, with every GOP chief facing a recession during his time in office. Donald Trump was the latest addition to this long list due to the recession caused by the COVID-19 pandemic.
While nothing is guaranteed, every Republican president eyeing a recession for more than a century is a worrying correlation for Wall Street. Although stocks and the US economy are not tied at the hip, economic contraction is expected to have a negative impact on corporate profits.
In fact: a study of Bank of America Global Research found that between 1927 and March 2023, two-thirds of the peak-to-trough declines in the S&P 500 occurred during, rather than prior to, the declaration of a recession. In plainer English, stocks perform poorly when a recession occurs.
Ominous warnings are piling up for the US economy and stock market
As Donald Trump prepares to take office for his second term, he will inherit a challenging set of circumstances. As the Dow Jones, S&P 500 and Nasdaq Composite have all galloped to multiple record highs in the aftermath of Election Day, ominous warnings for the US economy and Wall Street are starting to pile up.
US M2 money supply data according to YCharts.
For example, in 2023, the US M2 money supply suffered the largest annual decline since the Great Depression.
There have been only four periods before last year when the M2 money supply fell by at least 2% annually – 1878, 1893, 1921 and 1931-1933 – and they all coincide with periods of economic crisis. depression and double-digit unemployment. While a depression is highly unlikely in the modern era, a notable decline in the M2, thanks to the tools at the Federal Reserve and the federal government’s disposal, suggests that consumers may be making fewer discretionary purchases. is an ingredient for a recession.
Another source of concern is the longest yield curve inversion ever between three-month Treasuries and 10-year Treasuries.
Normally, the yield curve slopes up and to the right, with interest rates increasing the longer your money is tied up in an interest-bearing asset. But when investors worry about the economic outlook, the yield curve can invert, with short-term government bonds offering higher yields than government bonds. While an inverted yield curve is no guarantee that a recession will occur, every recession since World War II has been preceded by one.
We are also witnessing clear red flags from historically flawed valuation metrics.
S&P 500 Shiller CAPE Ratio data according to YCharts.
The S&P 500’s Shiller price-to-earnings (P/E) ratio, also called the cyclically adjusted P/E ratio (CAPE ratio), ended December 5 at 38.81, well above the average value of 17 .17 in backtesting. until January 1871. It also marks the third highest value during a sustained bull market.
More importantly, the five previous instances, over a 153-year period, where the S&P 500’s Shiller P/E topped 30 were ultimately followed by declines of 20% to 89% in the S&P 500 and/or Dow Jones Industrial Average.
The famous “Buffett Indicator” also pushes boundaries. The valuation tool that Warren Buffett praised earlier this century, which divides the market value of all publicly traded companies into US gross domestic product, reached a record high of 208% last week. For context, it has averaged closer to 85% since 1970.
Most signs indicate that the turbulence in the economy and stock markets will take shape sometime during President Trump’s second term.
Image source: Getty Images.
History also shows that patience consistently prevails
But there is a silver lining among these short-term warnings. More specifically, history is a two-sided coin, which favors patient investors far more than short-term traders.
Even though Republican presidents and recessions have gone hand in hand for more than 110 years, an even stronger historical connection is the nonlinearity of the economic cycle.
Since the end of World War II in September 1945, the US has weathered a dozen recessions. Of these twelve recessions, nine were resolved in less than a year, while none of the remaining three lasted longer than eighteen months. While recessions can undoubtedly be worrying and lead to emotion-driven moves in the stock market, they have historically been short-lived.
On the other side of the coin, there have been two periods of growth in the last 79 years that exceeded the ten-year mark. Most economic expansions will last for several years, which is why the U.S. economy and corporate profits grow over longer periods of time.
A similar story applies to the stock market.
Each year, Crestmont Research analysts update a data set examining the 20-year rolling total returns (including dividends) of the broad-based S&P 500 since 1900. Although the S&P didn’t come into existence until 1923, researchers were able to trace its components to other indexes prior to its creation – so the total return data is tested back to 1900.
What Crestmont Research found was that all 105 rolling twenty-year periods, with end dates ranging from 1919 through 2023, produced positive total returns. In other words, if an investor, hypothetically, had bought an S&P 500 tracking index at any time since 1900 and held that position for twenty years, he would have made a profit every time, regardless of which party controlled the White House during that time. . timeline.
Even as history rhymes again during Donald Trump’s second term, patient investors are well positioned for success.
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Bank of America is an advertising partner of Motley Fool Money. Sean Williams has positions at Bank of America. The Motley Fool holds and recommends Bank of America. The Motley Fool has a disclosure policy.
