While We Wait for the Flood…

07/12/2012 10:51 am EST

Focus: MARKETS

Howard Gold

Founder & President, GoldenEgg Investing

A number of experts have concluded that markets may be in serious trouble in 2013, but stocks could remain surprisingly strong right through the election and winter, writes MoneyShow editor-at-large Howard R. Gold, also of The Independent Agenda.

May was a rotten month for stocks, June was one of the best in years, and so far July looks pretty lousy.

And yet, for all the seeming turmoil and volatility, the S&P 500 index is pretty close to its April 2 closing peak of 1,419. Its recent closing low was 1,278 in early May, a pullback of roughly 10% from the high.

And that comes amid deep worries about Europe and slowing economies in China and here in the US. This could mean either the market is poised to make another big move down, or it may be some underlying strength.

Or everyone may be waiting for the Federal Reserve to jump in and untie the heroine just before the train runs her over. Problem is, we just don’t know, especially when stocks are so tied to macroeconomic and political events.

John Authers of the Financial Times wrote (registration required) that there hasn’t been a time in recent years when movements of stocks have been more correlated, or when stocks’ fundamentals have mattered less.

At times like this, I turn to market history for clues of what might lie ahead. It’s not perfect, but the market’s seasonal and four-year presidential election cycles have held up pretty well over time.

And they’re telling us we’re likely to have a rocky summer, a pre-election rally that could carry over through the winter, and then a big correction or even the end of the cyclical bull market that began in March 2009.

But that’s next year. 2012 still may be pretty good for stocks. Even after the recent shakiness, the S&P 500 is up 6.7% so far this year.

According to the Stock Trader’s Almanac, the Dow Jones Industrial Average posted average gains of 5.8% in presidential election years since 1833. That’s the second best year on average of the four-year presidential cycle.

And as I wrote last November, “during years in which incumbent presidents run for re-election, the market has beaten its average election-year performance significantly.

“It doesn’t matter if the incumbent wins or loses…or how good or bad a president he was.”

The Stock Trader’s Almanac’s editor in chief, Jeffrey Hirsch, told me he expects some turbulence over the summer months, which on average have produced much lower returns.

“The July-October period tends to be weak,” he said. That’s exacerbated during election years when, he explained, “there’s a tendency for the market to drift sideways over the pre-election period.”

In fact, he’s looking for the Dow Jones Industrial Average to fall to 11,500. (It closed above 12,600 Wednesday and peaked at 13,264 in April.) But then Hirsch expects a pre-election rally that may actually telegraph the election’s results.

If the market rallies in September and October, history suggests President Obama will be re-elected, Hirsch said. If stocks wait until November and then take off, it could mean Mitt Romney will win the White House.

In fact, according to the Almanac, “regardless of which party is victorious, the last seven months have seen gains on the S&P in 13 of the 15 presidential election years since 1950.”

NEXT: What’s Ahead in the Second Half

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Sam Stovall, chief equity strategist at S&P Capital IQ, backs that up. “85% of the time, the highs for the year occurred in the second half of a presidential election year, [and] 70% of the time in the fourth quarter, and that goes back to the 1900s,” he told me.

He doesn’t expect much of a correction this summer, either, and again he cited his own research into market history. Last year, we had what he called a severe correction or mild bear market. From April 19 until October 3, 2011, the S&P lost over 19% of its value.

But “since World War II, we have never had a price decline in excess of 10% in [the months following] these severe corrections/mild bear markets. We have only had pullbacks, not corrections,” he said.

That and reasonable valuations are why he thinks “we might surprise people and end up with a pretty good 2012." But after that? Neither Hirsch nor Stovall looks for the party to continue much longer.

“The market tends to give the new president or re-elected president the benefit of the doubt until the end of April” of the year following the election, Stovall said.

That might fit in with the dreaded “fiscal cliff,” when all the Bush tax cuts, President Obama’s payroll tax cuts, and extended unemployment insurance benefits expire at the same time automatic spending cuts of about $100 billion a year kick in.

If Mitt Romney wins and Republicans take over the Senate, the former governor has pledged to make the Bush tax cuts permanent and cut personal tax rates by another 20%, while Republicans may overturn many of the mandated cuts in defense (but not domestic) spending that are coming due. If President Obama is re-elected, we could have a repeat of the gridlock we saw in 2011.

The Congressional Budget Office estimates that if we go over the fiscal cliff, it would hit GDP by -3.6% in 2013. And since GDP growth now is about 2%, that would surely spell recession next year, and we could see the election-year stock bounce fade rather quickly as the calendar turns.

And speaking of the calendar, the six months from May to October of the year after a presidential election are one of the weakest periods in the four-year cycle.

That’s consistent with Hirsch’s expectation that we could see the next recession and cyclical bear market in 2013 and 2014.

So, here’s what I expect—a bumpy summer, but a floor on stock prices as the Fed prepares to step in with more quantitative easing if equity markets get hit hard.

Then, as fall comes, US stocks should work their way higher through the election. But the fiscal cliff will loom soon afterward, and either investors will sell or some surprise deal could push stocks higher still.

Yet, with the US and China slowing, Europe already in recession, and earnings growth running out of steam, I see a new US recession or bear market as very possible next year.

So, enjoy any rallies that the market gives us, take profits as stocks rise, and then get ready to batten down the hatches. Because all good things and all bull markets must come to an end.

Howard R. Gold is editor at large for MoneyShow.com and a columnist for MarketWatch. Follow him on Twitter @howardrgold and catch his coverage of politics and the 2012 presidential campaign on www.independentagenda.com.

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