Every four years, the presidential election tends to have a profound impact on the U.S. stock market.
Most of the gains in the Dow Jones Industrial Average since its inception have occurred in election years and the year immediately preceding them. The Dow has gained three times as much in the two years before a vote as it has in the two years after Election Day.
Looking a little deeper at this idea, we find that pre-election years tend to be the best years in the four-year cycle of the stock market, followed by a decline in the first half of the election year and, on average, a gain in the last six months of election years.
Since the 1944 election, the stock market has finished the election year with an average gain of 7 percent. If history repeats, that means the remaining months of this year would have to deliver explosive gains to make up lost ground.
If not, it will rank among the 25 percent of years when stocks experience a decline during an election year.
Yet, this year so far has been true to form, with a loss in the first six months. The underlying reason for losses during the primary season and gains as the general election approaches is that the market discounts the future.
In other words, uncertainty leads to volatility and market declines. When the future becomes more clear, that is, when a presidential winner emerges, the market tends to advance.
As a discounting mechanism, the market is less concerned with who wins the election than the fact that there is a definite front-runner. Once the election outcome becomes reasonably clear, traders can identify potential winning and losing sectors, and profit from their insight.
The impact of uncertainty in the market could be seen in November and December 2000, as stocks gyrated while the outcome of the presidential election wound its way through the legal system and all the way to the Supreme Court.
Stocks rallied once the winner was decided, but then reverted to form and declined in 2001 as the economy entered a recession. All signs indicate that history is repeating in 2008, with long and difficult recession swamping the economy into 2009.
Another important consideration in this year’s election is that the market delivers its best returns when one party controls Congress and the other party sits in the White House. When gridlock occurs on Capitol Hill, politicians can do little damage to the economy.
The Dow has delivered annualized gains of more than 19 percent under those conditions.
That didn't happen. Democrats picked up five Senate seats and 18 new House seats (three Senate races remain undecided; two more in the House are pending), which means they have a stronger grip on government, although not the supermajority Democrats would need to block GOP filibusters.
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