If You Bet on the Election,
Don't Use Real Money

Theories about Picking Stocks
Based on the "Presidential Cycle"
Don't Hold Up to Scrutiny

Every four years, as the clatter of the presidential campaign reaches a crescendo, Wall Street adds its voice to the din. Financial pundits spew forth one nostrum after another, often contradictory, never documented with evidence and always tailor-made to spur investors into making more trades. If you haven't yet heard "The stock market prefers Republicans," you will soon hear "The stock market prefers Democrats" or "Gridlock is good for investors."

Now that we know it's McCain and Palin against Obama and Biden, let me tell you three things about the "presidential cycle" in stock returns. There's not much to it, most of what you hear about it is wrong and there's no reliable way to make money on it.

From 1926 through the end of August, according to data from the market researchers at Ibbotson Associates in Chicago, the Standard & Poor's 500-stock index has done distinctly better under Democratic presidents (9.2% annually after inflation) than under Republicans (4.6%). While large stocks fared well in Democratic administrations, small stocks have skyrocketed, returning 16.5% a year after inflation, versus just 2.2% annually under Republicans. On the other hand, bonds have done much better in Republican than Democratic administrations (4.8% versus negative 0.4% annually, after inflation).

Heath Hinegardner

Why do stocks do better under Democratic presidents? Robert Johnson, a former finance professor who now helps run the CFA Institute (which trains financial analysts world-wide), has studied the phenomenon and found an explanation that has nothing do with party. In years when the Fed tightens the money supply by raising interest rates, the market does poorly; when the Fed eases by cutting rates, the market does well. Rate cuts are most common in the third year of presidential administration — helping explain why stocks have a significant tendency to do roughly twice as well in Year 3 of presidential terms as in years 1, 2 or 4.

Once you account for the market impact of the Fed's actions, the apparent predictive power of the presidential cycle evaporates; if you don't know whether the Fed will have to raise or lower interest rates, it doesn't matter which party is in power.

What about the nearly universal belief that "gridlock is good"?

Some pundits base that claim on numbers dating back to 1901. Dig into the data, however, and you discover that the gains from gridlock come entirely from a single year: 1919, when Woodrow Wilson, a Democrat, had to cope with a Republican House and Senate (and his own failing health). But it's absurd to give gridlock the credit for the Dow's 30.5% rise that year. Instead, it was the end of World War I, in the final weeks of 1918, that propelled the market to one of its best years ever.

The Stock Trader's Almanac, a popular reference book on Wall Street, reports that since 1949, the Dow has gone up by an annual average of 19.5% when the White House was Democratic and Congress was Republican. But that form of gridlock has occurred in just six of those 60 years, all under Bill Clinton, and in only 10 years in the past century. Such a thin slice of history is no basis for an investing strategy.

Overall, gridlock isn't good for investors. Since 1926, the S&P 500 has gained an average of 6.3%, after inflation, whenever one party controlled the White House and the other held the majority in both houses of Congress. That's less than the 6.8% annual average for the period as a whole.

What, then, should you do? The big margin of outperformance by small stocks under Democratic administrations might be worth betting on if you think Obama will win. But I wouldn't bet big on small-caps; they've beaten large stocks by such a wide margin lately that they are hardly a steal.

This time around, the credit crisis has made banks so reluctant to lend and borrowers so shaky that the Fed's recent rate-cutting push has hit the economy with all the impact of a piece of overcooked fettuccine. If the Fed has been rendered at least temporarily ineffectual, whoever is elected president may be forced to boost government spending in order to kick-start the economy. About all we can confidently say, then, is that this is unlikely to be a good time to add a lot of bonds to your portfolio.

Sometimes the most important thing for an investor to know is what not to do. Vote with your ballot; do not vote with your portfolio.