Enjoy the Party, the Market Isn't Overbought Yet. Tips on Trading the Post-Election Melt-up

There’s good news for U.S. stock investors. Jurrien Timmer of Fidelity Investments recently analyzed the S&P 500’s performance in the two- and four-year periods following presidential elections. His findings suggest that if historical trends hold, U.S. stocks are poised for robust gains, especially if Republicans achieve a “trifecta” by controlling the White House, Senate, and House.

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Although final results for the House races are still pending, projections from the Cook Political Report indicate a likely Republican sweep.

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The immediate surge in stocks post-election can largely be attributed to the unwinding of hedges, which has fueled a sharp rise in prices. While it’s challenging to predict how far this rally will go, the market is not yet considered overbought, allowing investors to benefit from the momentum.

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Valuation Concerns
However, there are reasons for caution, especially considering the bond market’s reaction to the election outcome.

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The S&P 500 currently trades at a forward price-to-earnings (P/E) ratio of around 22, a level significantly above its historical average. This elevated valuation means that the index is somewhat pricey by past standards, raising concerns about its long-term growth prospects.

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One factor heightening valuation pressure is the recent rise in the 10-year U.S. Treasury yield, which spiked following Donald Trump’s election win. The bond market’s response, with yields climbing to reflect higher inflation expectations and economic growth forecasts, could weigh on stock valuations. Although valuations may not be critical in the immediate term, they are essential for determining returns over longer periods.

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Federal Reserve's Potential Response
The Federal Reserve’s reaction to the recent market dynamics will be pivotal. Following the election, the 10-year yield increased by 0.15 percentage points, while the 2-year Treasury yield – a more sensitive indicator of short-term interest rate expectations – jumped by 0.8 percentage points.

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The current outlook from the markets is that the Fed might implement two quarter-point rate cuts over the next two months. These rate adjustments, if realized, could further influence stock valuations and bond yields.

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Maintaining a Bullish Stance in the Short Term
At present, a tactically bullish approach seems warranted. The high-yield bond market, as indicated by the strong performance of junk bonds, is moving in step with the S&P 500’s recent high, reinforcing the positive sentiment. This upswing in stocks, fueled by traders unwinding positions, is expected to persist over the coming days and weeks.

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Consequently, it appears premature for investors to take profits at this stage. Holding onto a bullish stance could allow them to capture further gains as the post-election rally unfolds.

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