2014 and the Presidential Cycle

01/31/2014 9:00 am EST

Focus: STOCKS

James Stack

President, Stack Financial Management

The road ahead is likely to become a little rougher as we head into this new year, and one reason is that 2014 is a mid-term election year, says Jim Stack, editor of InvesTech Market Analyst, money manager, and noted market historian.

In the four-year Presidential Election cycle, the Presidential Election year has historically been one of relative stability and generally positive outcome for the stock market. However, mid-term election years are anything but stable.

Since 1940, these years have averaged a modest 5.7% gain, but they have seen much greater variability in market performance than Presidential Election years.

While nine of the past 18 mid-term election years have ended with double-digit market gains, five have seen double-digit losses. Thus, this year could hold a few surprises.

Mid-term election years tend to experience significant volatility. We looked at the average quarterly performance for each year of the Presidential Election Cycle since 1940.

In Year 2 (which is the mid-term election year), the first quarter shows a small average gain of 0.7%; however, this quarter still saw modest losses about half the time.

More sizable losses are typically experienced in Q2 and Q3, with these being two of the three worst quarters of the entire cycle. On average, the S&P 500 (SPX) declined -2.2% in Q2 and -0.6% in Q3.

Delving a little deeper, the second quarter has been particularly weak, with negative returns for half of the 18 years in the study and double-digit declines in four of those years. The third quarter ended with losses seven times, and five of those were double-digit losses.

Yet, despite the poor track record for the first three quarters of the year, mid-term election years generally end on a strong positive note, with an average fourth quarter gain of 7.8% and the S&P 500 finishing the quarter higher about 90% of the time.

Based on these statistics, the odds of a significant market correction are quite high this year, and it's likely to occur in the second or third quarter.

A look at the past also shows that election dynamics don't rule out a new bear market. Three of the last 12 bear markets started in mid-term election years. Still, we don't want to be overly cautious, as the average gain for Q4 is the best of the entire Election Cycle.

With the recent technical strength in the stock market and improving economic reports, there's a definite possibility of additional gains this year; however, it's important not to abandon our safety-first strategy.

Market performance during the first three quarters of a mid-term election year can be particularly weak, and if this year follows historical precedent, there is likely to be a significant pullback, or correction, around mid-year. Thus, it's advisable to proceed with caution.

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