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The Best of Times For Stocks May Be Ahead

Shelly K. Schwartz,|Special to CNBC.com
Tuesday, 26 Oct 2010 | 2:22 PM ET

The midterm election may be setting the stage for a political power struggle in Washington, as Democrats and Republicans jockey for control of Congress, but it’s also stacking the deck for a much-anticipated Wall Street rally.

US Capitol Building at dawn
Allan Baxter | Digital Vision | Getty Images
US Capitol Building at dawn

As such, tactical investors should be reviewing their portfolios—and upping their equity exposure—to take advantage of any post-election pop, says Joe Zidle, an investment strategist for Bank of America Merrill Lynch.

“Right now there’s fear about the U.S.economy, regulation and taxes and those are legitimate concerns, but as we look at the market our view is that it’s actually a good time to be buying equities,” he says.

History seems to agree.

According to the Stock Trader’s Almanac, the market’s sweet spot during any four-year presidency cycle is historically the fourth quarter of the midterm year and first quarter of the pre-election year.

History also shows the markets have historically performed the best when there’s a Democrat in the White House and a GOP-controlled Congress—the likely outcome of this year’s midterm election, according to many.

Over the last 70 years, in fact, such combinations on Capitol Hill produced an average annual return of 15 percent or more.

Timing And Fundamentals

"There’s fear about the U.S.economy...but as we look at the market our view is that it’s actually a good time to be buying equities. " -Investment strategistBofA Merrill Lynch, Joe Zidle

Yet, there’s more to be bullish about than just the election.

Jeffrey Hirsch, editor-in-chief of the Almanac, notes that the months between November and April are generally good to investors. Since 1950, the Dow Industrials have returned an average 7.4 percent between those months, versus less than 1 percent (0.4 percent) between the May-October period.

Hirsch adds that a hypothetical $10,000 investment during the best six months of the year over that 60-year period would have yielded a $527,388 profit, compared with a $474 loss for the worst performing six months of the year during the same period.

“It’s the perfect storm of seasonality and historical patterns where the four-year cycle is lining up with the best months of the year for investors,” says Hirsch, noting he’s still waiting for the current rally to retrench before initiating long positions.

At the same time, Zidle, who co-authors the Research Investment Committee, RIC, Report notes the equity markets are getting a boost from accommodative monetary policy at the Federal Reserve and central banks around the world.

“We now have a very active central bank policy, which as been very good for equities,” he says, noting equities in certain asset classes are ripe for the picking after being beaten down for the last 5 years.

”Individuals have continued to pull money out of equities and put it into bonds and cash so in a lot of respects equities are the humiliated asset class—the contrarian trade. Historically, investors have done well to buy humiliated assets.”

Given such factors, BofA Merrill Lynch recommend moderate tactical investors overweight on equities and underweight on bonds, moving to a 65-percent stock, 30-percent bond and 5- percent cash split.

They should also up their allocation towards large-cap growth stocks to 40 percent of their equity holdings from 38 percent, by reducing their allocation to large-cap value to 34 percent from 37 percent, the RIC report advises.

The reason is two-fold: According to the report, large-cap stocks continue to trade at one of their cheapest relative valuations to value stocks in 30 years on a forward price-earnings basis, and “despite year-to-date underperformance versus small cap,” large caps have much greater exposure to sales and earnings growth from outside the U.S.

Indeed, global economic growth is expected to remain robust at 4.5 percent in 2010 and 3.9 percent in 2011, driven largely by strength in the emerging markets.

Thus, Zidle and other strategists recommend equities with exposure to the emerging markets. For that, you need not shop abroad. “The S&P 500 and other U.S. equities are much more exposed to global growth than most people understand,” he says.

Investors these days should also be focused on more high quality, income-producing stocks, says John Lynch, chief equity strategist for Wells Fargo Advisors.

“We need to look at the prospect of dividends,” he says. “From all that’s happened these past few years, I don’t think we’ll see price earnings expansions. If companies want to reward shareholder loyalty I think they’re going to have to buy it.”

Sector Scorecard

In midterm election years past, the stock sectors that have performed the best include technology, financial, industrial, consumer discretionary, and materials, while defense and energy stocks have lagged.

Things, however, are different in 2010.

Financial stocks, which enjoyed a strong rebound from the the brink of 2008, are mired once again in the foreclosure crisis, while healthcare and energy stocks are positioned for growth if the GOP wins Congress, says Lynch.

Market Pricing in GOP Win?
Is a victory for the GOP already priced into the equity markets or could we see a post-election rally? Jeffrey Kleintop, of LPL Financial, and Steve East, of Height Analytics, share their views.

“That puts healthcare and energy back in play,” he says. “It removes the risk of cap-and-trade [an energy tax to address global climate change], which has weighed down energy stocks and from a healthcare perspective it could alter [costly] regulatory legislation or even repeal it if Republicans take the Senate.”

The market, in fact, is already pricing in a Republican win, driving up the price of stocks most likely to benefit from a more business-friendly administration, says Kevin Rendino, senior portfolio manager for BlackRock’s Basic Value Fund.

“The group of companies that have been performing the best include healthcare, telecommunications, energy and some for-profit education companies,” he says.

If Democrats get more seats than expected, he notes, companies that would benefit from President Obama’s stimulus package, including infrastructure and alternative energy companies, will likely get a shot in the arm.

“The market is getting excited about the potential for a Democratic president and a Republican body of Congress,” says Rendino. “It’s going to be an exciting couple of weeks for sure.”

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