Market Outlook, September 21, 2004(A)

We first noted the importance of the so-called presidential cycle in our Market Outlook for January 2003. At that time the market was buried in the depths of an epic bear market that had begun almost three years prior. We stated at that time that we believed the market had made its final bottom in October 2002 and that stocks would improve over the course of 2003.
While various factors contributed to that (correct) view, the fact that 2003 would be the third year in a presidential term weighed heavily in our thinking. The historical record shows an uncanny regularity of stock gains in the third year of a presidency. Indeed, you have to go back to 1939 to find a market decline in the third year of a presidential term and even then the market fell less than 2%.
The track record for the fourth year of presidential terms is also quite positive, if less compelling than that of third years. Since 1926 the market has risen in 16 of the 19 election years. The general pattern is for stocks to go sideways for the first half of an election year and then gain altitude as uncertainty surrounding the election’s outcome dissipates over the second half.
And yet here we are in September and stocks remain stuck in a sideways pattern with returns for the year fluctuating around nil. This reflects in part, we suspect, the high degree of uncertainty that persists with regard to the outcome of the election. If you’re looking for signs of the market’s political preferences there’s no denying that the market softened following the Democratic convention as Senator Kerry moved ahead in the polls, only to strengthen following the Republican convention as President Bush reclaimed the lead.
That most denizens of Wall Street are Republicans–and so favor a Bush win–should come as no surprise. What may be surprising, however, is that the historical record is quite clear that the stock market does better during Democratic administrations than it does under Republicans. (Whether there is any causation behind this correlation is an altogether separate issue.)
While we’ve been looking at the influence of presidential politics on the markets, the folks at Ned Davis Research have found that the markets can also be forecasting tools for presidential elections. Poring over the record, NDR found the market tends to be weak leading up to elections where an incumbent president is unseated while a strong market leading up to November tends to predict re-election. Kerry partisans may thus take comfort from the market’s lack of vigor so far this year.
The fine points of political handicapping aside, there is little argument that investors and corporate decision-makers are “keeping their powder dry” pending the outcome in November. This “waiting and watching” attitude is keeping the stock market in check while corporate earnings continue to rise and cash hoards continue to swell. Which means that stocks are getting cheaper as the potential demand for them increases.
In looking out to 2005 the presidential cycle offers little help as the historical odds of the market going up (or down) in the first year of a president’s term are about 50/50. While much will hang on the outcome of the election, it’s good to keep in mind that the market hates uncertainty more than almost any particular outcome. Regardless of one’s political persuasion, come the morning of November 3rd a great deal of uncertainty should be removed from the outlook.