US stocks rally ahead of the midterm elections. Is it safe to buy?

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US stocks are off their lows, as reflected by the major indices. For example, the S&P 500 index is up more than 300 points from its October lows – and rising.

The bulk of the rally started last Friday. An article published by Nick Timiraos in the Wall Street Journal suggested that the Fed will discuss if it is suitable to lower the pace of the rate hikes from 75bp to 50bp.

“I think the time is now to start talking about stepping down. The time is now to start planning for stepping down,” said San Francisco Fed President Mary Daly during a talk at the University of California, Berkeley on Friday.

— Nick Timiraos (@NickTimiraos) October 22, 2022

While still tightening financial conditions, the Fed signals a slowdown, and thus, stocks rallied.

But besides the Fed’s decisions regarding the funds rate, another event has historically affected US stocks’ volatility. Midterm elections are due in the first half of November, and stocks have historically rallied after.

However, both bulls and bears have something to argue related to the midterm elections.

Most investors are short on US equities

A recent survey run by the Bank of America shows that most investors are short US equities. While it may look bearish, extreme positioning has often lead to major short squeezes in the market.

Moreover, there is plenty of cash available to buy, as shown in the graph below.

With the Fed in hiking mode, markets may have difficulties rallying

As mentioned earlier, historically, stocks rallied after midterms. But that was not the case when the Fed is in hiking mode.

This is why, perhaps, the Fed’s message from last Friday that it is preparing to discuss the slowdown in the rate hikes is important. If the market perceives that the Fed nears the terminal rate of this hiking cycle, and given the extreme positioning, then we might be in for a massive rally in the next couple of months.

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