Why a Late-Year Market Rally Could Be in the Cards

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Forget about stocks posting their best monthly performance in a year in July or the Dow's 200-point rally Monday (followed by a sell-off the next day.) The market has been range-bound -- albeit with high volatility -- for months. The S&P 500 ($INX) hasn't gone anywhere all year. It only turned positive for 2010 on Tuesday for a whopping return of -- wait for it -- 0.5%.

As Kenny Polcari, managing director at ICAP Corporates, an interdealer broker on the floor of the New York Stock Exchange (NYX), told DailyFinance,the market is stuck because bulls and bears are trying to square an apparent V-shaped recovery in corporate profits with a bunch of economic data that point to slower -- perhaps much slower -- growth ahead.

So what will break this tug-of-war tie between the bulls and bears? The mid-term elections, writes Jeffrey Kleintop, chief market strategist at LPL Financial, the Boston-based broker-dealer. It just so happens that such political drama tends to act as "a catalyst for a late-year stock market rally," Kleintop tells clients in his weekly market outlook.

A Typical Pattern

"So far, the stock market performance in 2010 has tracked the typical pattern for U.S. stocks in mid-term election years, albeit with a bit more than the usual volatility," Kleintop writes. "The path is usually range-bound and volatile, but capped by a strong fourth quarter rally averaging about 8%."

Considering that over long periods of time equities are lucky to return 10% annually (some of which is just inflation), an 8% market rally this holiday season would be a lovely way to ring in the new year.

Interestingly, since World War II there have been only two mid-term election years -- 1978 and 1994 -- in which the market didn't get that fourth-quarter pop, Kleintop writes. As for the two times the market failed to muster a late-year rally, well, "during both of these years the Federal Reserve was aggressively hiking interest rates," Kleintop writes.

Now, as every investor should know, past performance is not indicative of future returns, but just take a look at the chart below, courtesy of LPL Financial. There's no question this mid-term election trend is a balm for the bulls.

But enough with the charts. It's no secret that the economy is slowly and painfully adjusting and deleveraging as it morphs into something called the New Normal. It really is different this time -- in a bad way.

It's All About Uncertainty

And yet Kleintop remains bullish on stocks following what promises to be an unusually bitter and bloody political contest, even by Washington's standards. So what gives? It's a cliche, but it's true: The market hates uncertainty -- especially when it comes to taxes, Kleintop says.

"The elections may mark a shift away from the uncertainty surrounding the potential for sweeping legislative changes," writes Kleintop. "Given the shifting sentiment on taxes the elections may be followed by Congress enacting fewer tax hikes for 2011 than are currently expected by market participants."

The market, by the way, is nonpartisan in this trend. Stocks have historically taken off after mid-terms regardless of the results, Kleintop notes. In other words, investors just want to put the mid-term elections behind them as quickly as possible. Amen.