Could an October Surprise Lift Stocks?

It's no secret stocks have been languishing for months. The market suffered its worst August since 2005, leaving the S&P 500 ($INX) off 5% on the year. It's also no secret the November mid-term elections are likely to be especially bitter, given that unemployment remains persistently and perniciously high.

But it just so happens that stocks have a history of posting impressive gains in the fourth quarter of a mid-term election year, notes Jeffrey Kleintop, chief market strategist at LPL Financial. Furthermore, Kleintop sees a number of potential catalysts tied to the mid-terms that could boost shares. From an October Surprise to gridlock in Washington, D.C., there's a host of outcomes that could cause equity investors to celebrate.

Among the more interesting potential catalysts related to the mid-term elections is the possibility of a so-called October Surprise unveiled by the Democratic party in order to save incumbent seats on Nov. 2. As Kleintop told clients in a report this week: "Incumbents are in trouble according to state and regional polling data. In seeking to turn the tide of voter sentiment, [Democrats] may talk about tax cuts or other issues favorable to stock market investors."

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Then there's the very real possibility that the mid-terms will end with neither party having enough votes in congress to get anything of substance done quickly -- if at all, Kleintop writes.

"The balance of power is likely to shift between political parties following the elections," says Kleintop. "This may lead to more of a political balance in Washington and slow the pace of legislative change resulting in the 'gridlock' the market has historically favored."

Another mid-term election effect that really stands out the market's historical pattern. Stocks have actually tracked a typical pattern for equities in a mid-term election year, Kleintop notes, albeit with more volatility than usual. That bodes well because the market has averaged a gain of nearly 8% during the fourth quarter of mid-elections years going back to 1950.

If past results are indeed indicative of future returns, stocks would reverse course in the next couple of months to end the year with single-digit-percentage gains, Kleintop says. For a look at the S&P 500's fourth-quarter performance in mid-term election years, see the chart below, courtesy of LPL Financial and Bloomberg.