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In Election Year, January Is Even More Crucial for Markets

Tuesday, 3 Jan 2012 | 2:48 PM ET

Presidential election years typically spell tough sledding for stocks, so the market will need all the help it can get from January to establish some positive momentum in what promises to be a volatile political landscape.

While the January Effectand its closely watched cousin, the January Barometer, are usually good market predictors no matter the year, the correlation is especially prevalent during the final year of the presidential cycle — when voters either re-elect an incumbent or choose his successor.

Since 1945, a positive January in an election year has never missed in predicting a full-year gain for the Standard & Poor's 500 , going 8-for-8 and posting an average gain of 16 percent, well above its normal average, according to Sam Stovall, chief equity strategist at S&P. A negative first month, meanwhile, has predicted a full-year loss 56 percent of the time, with an average 3.9 percent decline.

"Whatever the S&P 500 doesn't provide in absolute return this year, it will likely make up for in predictability," Stovall said in a research note.

However, 2011 was anything but predictable when it came to following the election-cycle script.

The third year of the cycle is supposed to be the best one for stocks, with a stellar 16.1 percent gain the historical norm. But sovereign debt storm clouds over Europe, as well as political and fiscal uncertainty in the U.S., made trading volatile, with the market's fluctuating violently within a fairly tight trading range.

That break from the norm could cause a deviation from what normally would be expected from the fourth year of the cycle.

"People are sort of done with what's going on," said Nadav Baum, executive vice president at BPU Investment Management in Pittsburgh, Pa. "Something in Europe is going to come to a head, and they're looking at this and saying, 'Wait a minute, U.S. domestic companies have never been in better shape.' They're doing all the right things if there weren't for all these crazy headlines."

Baum thinks fatigue over Europe and the U.S.Republican primaryrace will push investors to focus on bargains in the stock market and away from geopolitical turmoil.

"This is a very inexpensive market," he said. "The problem is the emotions start to cloud the investment decisions because everybody gets nervous. That's why you're getting all the whipsaw trading and volatility."

History, though, suggests that the market will slog through most of the year and wait to rally until the election is over in November.

While much has been made over the old maxim that the market loves gridlock, the opposite is actually true. A divided Washington has provided the lowest market returns, while complete Republican control or a Democratic president with a full Republican Congress have proven the best times.

"We doubt this year’s contest will prompt a significant upturn in the stock market," John Higgins, senior market economist at Capital Economics in London, said in a note. "After all, the economy looks set for another weak outturn, profit margins are stretched and valuations do not appear especially attractive from a historical perspective."

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Any enthusiasm for a changing of the guard could be short-lived, he added.

"There is no real room for further fiscal stimulus," Higgins said. "What’s more, while the stock market has tended to do better since 1928 in an election year when the eventual winner has been a Republican rather than a Democrat, it has actually done comparatively worse the following year."

Investors, meanwhile, likely will have cast their votes already by the time the actual election date rolls around.

The three months leading to previous elections have proved accurate predictors 88 percent of the time — when the market is up from July 31 through Oct. 31, the incumbent or his party wins, and when it's down the other side gets the nod.

"The economy sets the tone for the election," said Jim Paulsen, chief market strategist at Wells Capital Management in Minneapolis. "Whoever wins the election, whether it be Obama or the Republican, will be forced to the middle in their management. That's what's important for the markets."

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