What Happens to the Stock Market in an Election Year?

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With just about six weeks to go until Nov. 6, many investors are wondering how Election 2012 will affect the stock market as a whole and their portfolios in particular.

There are many theories about what can happen to the stock market following a presidential election – although the performance spread is pretty wide.

The highest election year return for the Standard & Poor's 500 Index takes us back as far as 1928, when Herbert Hoover beat Al Smith. The S&P 500 returned 43.6%.

But the heady atmosphere just before the 1929 stock market crash probably had more to do with that high return than Hoover's election-or Smith's loss.

The lowest return in the 80-year period came in 2008, when now-President Barack Obama beat John McCain. The S&P 500 dropped 37%. Once again, the 2008 financial crisis probably had a greater impact on that result than who won or lost the election.

So what is likely to happen four years later, with the economy still struggling to recover and the S&P 500 ahead about 15%?

Let's take a look.

Election Year Theories: All Over the Board

Yale Hirsh's Presidential Election Cycle Theory is one of the best known stock market performance theories. It simply says that stocks decline in the year following an election, regardless of which party wins, and improve over the next three years.

Ned Davis Research similarly says that between 1900 and 2009, stocks have generally delivered their best performance in the final two years of a presidential election cycle. The Dow Jones Industrial Average returned an average of 12.9% in the third year and 7.5% in the final year in that more than 100-year timeframe – which bodes well for 2012.

But, before you get comfortable betting on a winning season, take into account that recent evidence contradicts those results.

Of the three years so far in the Obama administration, market performance in the first year, 2009, was the tops at 18.8%. The lowest was year three, 2011, at 5.5%.

And consider the administration of George W. Bush. In his final year in office, the Dow lost 33.8%.

While it's hard to determine whether an election year will deliver strong market performance, it seems clear that which party occupied the White House has seemingly had no significant impact on the U.S. stock market.

Which party controls Congress, however, does factors into the equation. An MFS Investment Management research report concluded that a Democratic President and a Republican Congress produced the best historical returns in the period 1961 to 2010 based on the S&P 500. That combination produced an average return of 21.3%.

When the White House and Congress were controlled by the same party, the average S&P 500 return then was 12.1%.

Election 2012 and the Markets

These mixed results should lead you to one conclusion: It's most important to design an investment portfolio that meets your financial goals, income requirements, risk tolerance and time horizon.

That means looking at what each candidate means for the big picture, and how his policies will shape our economy and move stocks.

Despite the lack of proof that presidential elections have a significant impact on stock market performance, there are some things to think about in 2012:

  • Deficit reduction: Mitt Romney and his running mate Paul Ryan have deficit reduction on their minds. Reduced government spending could have a significant impact on certain industries, including construction, technology and defense.
  • Obamacare: Stocks declined after the U.S. Supreme Court affirmed the bulk of the Obamacare legislation in June 2012. With Republican Mitt Romney threatening to eliminate much of the legislation if he and his party gain control in November, look for healthcare-related stocks to be affected if the program is slashed.
  • Tax cuts: President Obama ways he wants to let the Bush tax cuts expire if he is reelected. Since the stock market generally likes lower tax rates, watch out for market backlash if the cuts indeed expire and investors have less money in their paychecks.

Bottom Line: Bet with Your Head: As most investment advisers tell us regularly, past performance does not guarantee future results. Even when history shows that something usually happens following a presidential election, there is no guarantee that it will happen. If you decide to take a small gamble, do your research on who is likely to win and what he'll likely do first.

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