How to Play the Election Year Stock Market

How to Play the Election Year Stock Market

Research has shown that the stock market tends to go up during a presidential election year.

Ned Davis Research long ago identified a presidential stock market cycle. Returns during the first year of a presidential term average about 5 percent. Gains in the second year average only 4 percent. But the third year typically sees a jump of 12 percent, and the fourth year (the presidential election year) brings a further 8 percent gain.

Applying the presidential cycle theory, 2012 should be a good year for stock investing. And so far it has been correct.

A study by Marshall Nickles of Pepperdine University concluded that bear markets typically bottom during the midterm congressional elections, then rise during a president's third and fourth years in office.

Nickles tested data from 1952 through 2000 and found that an investor who bought stocks and held them for the first two years of presidential terms, then sold them, would have made money six times and lost money seven times. In the end, he would have lost nearly half his money.

An investor who bought and held stocks in the second half of presidential terms, and then sold on the day the presidents were inaugurated, would have made money every time, for an overall gain of more than 7,000 percent.

Nickles and others caution that while the presidential cycle theory is historically accurate, it does not necessarily predict stock prices. The market is subject to various forces, many of them unforeseeable, and a recognized pattern may not anticipate the next turn in the market. Ask anyone who invested at the beginning of 2008, the last presidential election year. The SP didn't get anywhere near its 8 percent average. In fact, it lost a whopping 37 percent for the year.

Nothing in this world is certain, but the stock market is a game of probabilities. And another report from John Hancock Mutual Funds confirms that the stock market ekes out small gains during a president's first two years, then goes up a lot during the president's second two years. John Hancock puts the chances of a gain during the presidential election year at 74 percent.

In the last ten presidential election years, the market has been up eight times and down twice. Not bad odds. However, if the expected gain during a presidential year is about 8 percent, and as of late April the U.S. stock markets are already up 9 percent, then that doesn't necessarily bode well for the rest of 2012.

Does it matter who wins the election? Some investors believe Democrats are bad for business, on the theory that they raise income taxes, impose more regulations, and increase labor costsâ€"all leading to lower corporate profits. But perhaps extra government regulation also brings more openness and transparency to business, and Obama's push to build out the infrastructure and develop alternative energy could end up creating more corporate profits.

The fact is, over time, neither Republicans nor Democrats have proved to be better or worse for the stock market. The market was bad under President Carter and good under Reagan. Then it was good for Clinton, but bad for Bush.

In presidential election years when the incumbent went on to win reelection, including George Bush in 2004, Bill Clinton in 1996, and Ronald Reagan in 1984, the stock market averaged better than 12 percent.

Meanwhile, in 2000, the last time a Republican took over the White House from a Democrat, the SP 500 lost 10 percent. But when Ronald Reagan beat out Jimmy Carter in 1980 the stock market jumped up 26 percent.

One conclusion might be, if it looks like Obama is going to win, stocks will continue to edge up for the rest of the year. If it looks like Mitt Romney will pull an upset, then the market might surprise us. It could interpret a Romney win as a signal of better times ahead and rocket to higher levels, or it could take it as a sign that things are worse than everyone thought and plunge into negative territory.

But mark your calendar. If you believe this theory, the presidential cycle tells us that we should hang onto our stocks for the rest of 2012. But it also says we should sell when the president is inaugurated in January 2013â€"no matter who wins.

Tom Sightings is a former publishing executive who was eased into early retirement in his mid-50s. He lives in the New York area and blogs at Sightings at 60, where he covers health, finance, retirement, and other concerns of baby boomers who realize that somehow they have grown up.