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Elections and returns

In the October issue of the Sound Mind Investing newsletter, we reported on The Impact of the Election Cycle On Annual Seasonality (subscribers' link). Here are a few excerpts:

Each year contains a six-month period that is generally "favorable" for stocks (November through April) followed by a six-month period that's generally "unfavorable" (May through October).... Stock market strength/weakness [also correlates with] the four-year [presidential election] cycle closely enough that, over time, clear trends have become evident....

[T]he unfavorable period of [a president's second year] (corresponding to the six months leading up to the midterm elections) has been especially bad, and the favorable period of year three (i.e., the six months following midterms) has been especially good.

In other words, we are coming out of a period that, historically, has been tough sledding for the market and entering a six-month period of time when the stock market has shown particularly strong performance.

Why market returns typically improve following a mid-term election is anyone's guess. And, of course, past performance is no guarantee of future results (as the legal disclaimer goes).

In this particular case, some of the push higher surely is driven by the fact that it looks likely (but it ain't over till it's over) that Republicans will take the House half of Congress. They might even take the Senate.

Many (not all) investors, unhappy with what they see as an overly activist government — or at least a government that has created significant uncertainties in the marketplace — are hoping for what Washington watchers call "gridlock" (i.e., little gets done because the policy differences are just to broad to reach agreement).

But as a J.P. Morgan official said last week (quoted yesterday in the Wall Street Journal), "Gridlock surely promotes the status quo but that is not great in a time when action is needed." In other words, stopping something is not the same as doing something.

From the WSJ:

The main question is what a gridlocked Washington would do if faced with a new recession or financial crisis. But other issues abound: the future of Fannie Mae and Freddie Mac, which control a huge proportion of the nation's mortgages, Medicare and Social Security costs, trade disputes and other issues involving China, the moribund housing market, unemployment.

Gridlock, if it occurs, may not emerge right away, however. Keep in mind that before the new Congress is seated until January, the lame-duck Congress will still have several weeks in which to pass bills to the president's liking — such as extending tax relief only for certain taxpayers. Doing so could leave many investors with significantly higher tax liabilities (subscribers' link) in 2011. (Note: The make-up of the Senate could change slightly before January because of a special election in which the winner will be sworn in shortly after the election is decided.)

Also in the mix in the weeks ahead: the final report (due Dec. 1) from the president's deficit commission (the National Commission on Fiscal Responsibility and Reform). It is unlikely the outgoing Congress will deal with any suggestions therein, but the report's recommendations could set up some bruising legislative battles in the new year.

What all this means for the investing climate no one can tell, especially with the Fed pumping even more money into the economy. One thing seems likely: there will be no shortage of confrontations, speculations, and congressional investigations.

Our advice? Find an investing approach your nerves can handle and do your best to tune out the noise.

I talked about some of these issues in an interview that will air this afternoon on The Meeting House from Alabama's Faith Radio. Host Bob Crittenden played a 3-minute preview of that conversation on yesterday's program. Listen below.

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