Election Year Markets – January 2012

January 19, 2012

Dow Jones Average: 12,578
S & P 500 Index: 1,308


Election Year Markets

The stock market in the U.S. has a long history of rising during Presidential election years. There is reason to believe that the high correlation with the four-year Presidential cycle is more than coincidence. The political party that holds power has a strong interest in bolstering economic conditions in the months leading up to the election. More difficult, unpopular policies are implemented early in a President’s term, while tax cuts, spending programs, and low interest rates, are the policies of choice in the later two years of the cycle. It is no accident that the economy and the stock market are typically looking good around Election Day.

Over the past fifty years the stock market has gained ground in all but two Presidential election years. It is notable that both of those exceptions, 2000 and 2008, came recently. The classic pattern of economic difficulties at the beginning of a President’s term, followed by economic strength going into an election year is clearly borne out by the statistics. The economic contractions of 1970, 1981-1982, 1990, and 2001-2002, occurred early in the Presidential cycle and were over before the ensuing election. The political calendar drives economic policy. The incumbent party tries to make things look as good as possible by Election Day, while pushing problems out to another day or a different administration.

The typical pattern of market strength in election years has become frayed in recent years, as serious financial bubbles have become increasingly difficult to control. After years of high-tech driven growth and booming stock market gains, the Federal Reserve felt compelled to arrest the dot.com bubble in early 2000. The Fed made the highly unusual move of raising interest rates at the beginning of a Presidential election year. The result was a down year for stocks, a slower economy, and the defeat of Al Gore, the incumbent party standard bearer. The economy was in a post-bubble decline by the time George W. Bush was sworn in as President. The usual remedies of tax cuts, increased government spending, and low interest rates revived the economy by just enough to produce a narrow win for President Bush in 2004. A side effect of the Bush Administration policies was a real estate bubble and financial meltdown that became uncontrollable by 2008. The stock market crash of 2008 was a shocking exception to the thesis of positive returns in election years.

The financial chaos in 2008 ensured the election of Barack Obama, who won by the largest popular vote percentage in decades. With that big victory he inherited the biggest economic mess since the 1930’s. The economic manipulation designed to goose the economy before elections often has a deleterious effect that becomes apparent after the election. While many new presidents have been greeted by a faltering economy soon after taking office, the conditions that President Obama faced were closer to a depression than an ordinary recession.

The Obama Administration unleashed a flood of money in an effort to stimulate the economy. The administration passed the biggest stimulus plan since WWII and cut the payroll (FICA) tax, while the Federal Reserve has pushed interest rates to zero percent. It has taken extreme measures to jump start an economy weighed down by a moribund housing industry. One cannot overstate the impact of the real estate boom and bust that took place between 2003-2007. Economic recoveries and job creation are often led by the homebuilding sector, but this badly damaged industry has not contributed at all to the current recovery. Despite the considerable drag from the housing sector, more than two million private sector jobs have been created, the economy has grown at a modest pace, and the stock market has continued its steady recovery from the depths of 2008-2009. Whether these positive trends continue remains to be seen. In a global economy, events in Europe or China could upend the incipient progress in the U.S. economy. For now it appears the Obama Administration may have engineered an improving economy and stronger stock market in time for the election season.

Current Strategy

The stock market in the U.S. showed little progress during 2011, while markets overseas generally lost ground. The Standard & Poor’s 500 Index closed the year at 1257.60 which was .04 of one point less than the 2010 closing level. We cannot recall two years that ended that close together. The S&P 500 Index did earn 2.1 percent for 2011, when dividends from the 500 S&P companies are included in the return. The stock market did not keep pace with the growth rate in corporate profits, indicating that much of the gain in corporate profitability was already built into stock prices. Investor worries about future threats to corporate profitability, particularly from Europe, restrained stock appreciation in 2011.

We do anticipate an upward bias to stock prices in this election year, although the unusually strong gains in 2009-2010 may limit the potential for a large election year gain. We do not see some shock to the market as occurred in 2000 or 2008. There are no bubbles for the Fed to break this time. Interest rates are at rock bottom in the U.S. and likely to stay that way. A probable recession in Europe and a decline in China’s growth are the biggest threats to stock prices this year. Even though we think stocks will most likely trend higher, that does not mean they are cheap. Stock prices are close to average in many cases, and expensive in some instances. After several years of price appreciation, there are few, if any, companies that are substantially undervalued in our opinion. Nevertheless, we are alert to changing company circumstances and stock price fluctuations that may produce buying opportunities.

The fixed income part of portfolios continues to be a struggle for us. Bonds that we bought in the past at favorable interest rates are maturing, and we do not see good replacements. We continue to evaluate foreign bonds, but recognize that they represent a currency trade, as the underlying interest on the bonds is often negligible. With the U.S. Dollar gaining in value since August, foreign bonds have not recently been a good alternative to low U.S. interest rates.

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