Trader’s Narrative

Just before 2010 started, I showed a chart of the average returns for the S&P 500 index for mid-term election years. According to this chart, if 2010 followed the previous precedents, it would be a flat year. The year isn’t over yet but so far, that has proven to be a very accurate forecast.

The S&P 500 index started the year at 1116.56 and today it closed at 1125.07 - almost unchanged. We saw a modest peak in April that took the S&P 500 index approximately 9% higher and a valley in late June 8% below. Overall, it has been a very humdrum year. But that is about to change based on the four year US election cycle.

In about 2 weeks we will enter the final quarter of 2010 and according to historical trends, this is the best time for equities within the election cycle. The best annual returns occur in the pre-election year (2011) but the “sweet-spot” starts one quarter earlier, at the end of the mid-term election year.

Here’s a chart from Ned Davis Research which shows the geometric mean of the S&P 500 index (1930-2009) during the election year cycle:

Source: Autumn Leaves… and Election Cycles

The quarter that we are about to enter is in fact, the single best performing quarter in the whole 4 year cycle. You can see a quarterly chart below:

The pre-election year, 2011, is the best annual return within the 4 year cycle. But if you want to find the perfect entry point, it would be October of the previous year.

The developing consensus for the mid-term elections is that the Democrats are expected to lose their Congressional majority and perhaps even control of the Senate. According to research by the Leuthold Group, such a “gridlocked” government is actually very good for the stock market. In fact, the combination of a Democratic presidency with a Republican Congress provides the highest average annual return (9.6%) of any political permutation. It is also the rarest, having only occurred 9% of the time in US history.

So if we do see a change within the branches of the US government, that will provide a historical backdrop for an even bigger boost for the stock market, above and beyond that provided by the election year cycle. But before you start celebrating, remember that this is simply an average historical precedent and in no way dictates that the stock market must unfold in the same way.