Stocks tend to fall in 3Q of midterm election year

July 16, 2006|By JAY HANCOCK | JAY HANCOCK,SUN COLUMNIST

One of the most implausible investment theories is the one that predicts stocks will take a steep dive partway through a midterm election year and stay down until Octo- ber.

So far this year, it's working perfectly.

Stocks' tendency to fall in the second year of a presidential administration may be a coincidence of the calendar. But it's a coincidence with decades of history, which means it's hard to explain by assuming stocks move randomly, which means it may not be a coinci- dence.

And if it holds for the rest of the year, stocks will suffer more pain in the next couple months. Then they'll recover in a fabulous way.

This year seemed to begin well for stocks. Standard & Poor's index of 500 big-company shares rose 4 percent by early May, conforming to its habit of early gains in years when the country prepares to elect a new Congress but not a president.

"At least for the moment, you have to look at the market in a positive light," a guru for Schwab CyberTrader told the Associated Press on May 9.

But as the politico-financial soothsayers could have told him, it was going to be a short moment.

Of the 16 fiscal quarters in every four-year presidential term, the least favorable for stocks has been the third quarter of the midterm election year, says Sam Stovall, chief investment strategist for Standard & Poor's.

Which would be now, when stocks are cratering.

The second worst is the second quarter of a midterm election year. Which would have been last quarter, when the S&P 500 fell 2 percent.

"Boom: It really jumps out at you that in year two of the cycle, the one we're in now, that the second and third quarters are by far the worst" of the four-year period, Stovall says.

The pattern isn't wholly consistent. But it's consistent enough that you could have made good money (if you sold stocks short during those periods) or avoided losses (if you stayed out of the market) nearly three times out of four in the past few decades, Stovall says.

Analysis by Ned Davis Research, of Venice, Fla., and others shows similar movement by the Dow Jones industrials.

Since 1945, the S&P 500 index has fallen an average of 2.2 percent in the July-September quarter in a midterm election year, Stovall's research shows. It fell an average of 2 percent in the April-June quarter of those years.

That contrasts with an average quarterly gain for the S&P 500 of 2.2 percent for the 50 years. And it contrasts even more with an average gain of 7.6 percent for the index during the best quarter in the four-year election cycle. (Which I'll discuss in a moment.)

Recent history tells the tale of the midterm-election summer. The last midterms were in 2002. The third quarter of that year brought us the Global Crossing, Adelphia and WorldCom scandals and a stunning 18 percent decline in the S&P 500.

The midterm year before that was 1998. That summer emerging markets continued to collapse, Long Term Capital Management went belly up and the S&P 500 dropped 10 percent. In 1994 the index threw a curveball, rising 5 percent in the third quarter. But in 1990 the third-quarter loss was 15 percent, as recession and banking crises took hold.

And so on.

The midterm-election effect is helped by the "sell-in-May-and-go-away" pattern, which shows that summer in any year is usually a bad time to own stocks. But midterm-election summers are worst.

Starting in 1962, when the pattern begins to look especially strong, avoiding the market in the middle of midterm election years would have meant gaining an average of 9.5 percent each year on the S&P 500 (not counting dividends) versus only 6.7 percent if you had bought and held, Stovall says. If you had invested $1,000 in 1962, that's the difference between having $17,000 now and $54,000.

What's the explanation? The attraction of analysis like this is that you don't need an explanation. Just obey the numbers.

But effects seem to demand causes. The gurus suggest that, at this point in the cycle, fiscal adrenaline injected for the previous presidential election has worn off.

Think about President Bush's tax cuts, defense-spending increases and accelerated depreciation to encourage capital investment. All are receding into the past. The waning stimulus has affected stocks, the explanation goes.

Dumb me. I thought stocks were falling because of international crises, record oil prices and rising interest rates. As a buy-and-hold index-fund guy, I'm skeptical of almost any market theory except the one that says U.S. equities deliver superior returns over the long term.

But history does seem to be repeating itself. And here's what history says about the rest of the year. For the past half-century, the very best period to own the S&P 500 was the last three months of a midterm election year, with a 7.6 percent average gain.

This suggests stocks will recover handsomely from their slump, starting in October. If it happens, you could attribute it to anticipation of fiscal stimulus for the 2008 presidential election. Or you could credit falling oil prices, easing interest rates and waning international tension. Either way, you might not want to bet against it.

jay.hancock@baltsun.com

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