Presidential profit? Stocks and elections

by Jim Stack, editor Investech Market Analyst

What lies ahead in 2012? That’s the big question, and the fact that we’re approaching a Presidential Election likely improves the chances that this will be a good year for the stock market.

Historically, there has been a clear visible link between the Presidential Election Cycle and Wall Street. Below, we look at the correlation between cycles in the stock market and the 4-year election cycle.

Off-election years are often preceded by bear markets or stagnant growth and typically provide some of the best buying opportunities for stocks.  

However, one rarely sees the market swooning in the 12 to 18 months leading up to a Presidential Election – 1960 and 2008 are the notable exceptions.

If you think about it, this relationship makes sense.  Any politician worth his salt knows that you should try to get bad news and bear markets out of the way as quickly as possible after taking office.  

That way, the economy and the stock market can get back on track and be ticking along smoothly when it’s time to run for re-election.  

You rarely see Washington passing controversial tax hikes or legislation once the Presidential campaigns get rolling in earnest, and even the Federal Reserve, which is not supposed to be politically influenced, is reluctant to rock the boat by significantly increasing interest rates during an election year.

Historically (since 1941), the first two years after a Presidential Election have the lowest performance, with average annual gains less than 5.5%.

Year 3, as politicians start gearing up for re-election, is usually the best on Wall Street by a wide margin. With an average gain of 17.3%, it more than doubles the return of the other three years.  

Presidential Election years tend to be more moderate, but historically are still the second most profitable in the cycle. Before the financial crisis, the average annual gain for election years was 8.9%; however, the 38% drop in the S&P 500 in 2008 reduced the long-term average to 6.2%.

The current 2009-2012 Presidential Election cycle is anything but “average.”  After the 2008 debacle, the bull market recovery came early.  

Years 1 and 2 were far stronger than usual, which likely stole performance from Year 3. Consequently, 2011 fell far short of expectations, ending with 0% gain in the S&P 500 after it suffered a sharp bearish contraction mid-year.  

Although the progression up to now has been atypical, what are the odds that this election year will be closer to the norm?  In seeking the answer we looked back at prior cycles, where historical precedent has not always prevailed.

Election years can be volatile (what years can’t), but they rarely end with big losses for investors.  

We looked at every Presidential Election year since 1900 along with the gain or loss in the DJIA (excluding dividends). Note that: 

• The average gain for these 28 election years is 7.3%, which is equivalent to the average annual market gain taking all 112 years into consideration.  However, if we exclude 2008, which was the worst Presidential Election year in over a century, the election year average jumps to 8.8%. 
  
  
• Two-thirds of the periods were positive for the market, while years with major losses were rare. 
  
  
• Election years that showed double-digit gains outnumber those with double-digit losses by nearly 3:1 – and only one of those double-digit losses occurred after 1940. That was in 2008 when the economy was deep in recession at election time (which was also the case in 1960), and it cost the incumbent party dearly at the polls.

Our study also revealed another secret in Presidential Election years… the market often rallies in the second half of the year. 

• In all but six election years, the DJIA either hit a new yearly high, or came within 5% of the year’s high, in the 4th quarter. 
  
  
• There have been only five elections where the market dropped to a new yearly low in the 4th quarter, and three occurred during major recessions – 1920, 1932 and 2008. 
  
  
• In 2004, the 4th quarter saw both extremes.  The low was hit in October, and the DJIA rallied to its high for the year in December.

Looking at 2012, the year has started off with good news on the economic front – leading data is improving along with confidence and recession fears are receding.  

Also, the technical picture is more encouraging, with stronger market breadth and the disappearance of bearish distribution.

In our opinion, this evidence, along with the Presidential Election Cycle, reduces the chance that this will be a down year for the market.

In our Model Portfolios, we are currently 77% invested, but we’ll likely step up from this level if fundamental and technical models continue to improve.

Learn more about this financial newsletter at Jim Stack's Investech Market Analyst.