Elections Could Cause Stocks to Rally

The connection between politics and stock market gains could become more evident as voters head to the polls for the midterm elections and as Barack Obama heads into his third year as president of the United States. If historical trends hold true to form, the U.S. stock market could experience a rally that extends at least 90 days after the midterm elections, and next year during the third year of a presidential term, the stock market could match gains that have averaged more than 10% dating back to 1871.

Brian Gendreau, market strategist for Financial Network Investments, has completed a study revealing that the Dow Jones Industrial Average has risen in the 90 trading days following 19 of the past 22 mid-term elections by an average of 8.5%. Gendreau studied changes in the Dow during all midterm elections that occurred between 1922 and 2006 and says the pattern of the stock market rallying after midterm elections should hold consistent this year, as the Republicans seem poised to gain seats in the House of Representatives and the Senate.

"It's a pretty strong historical pattern that doesn't work every time, but is a little too hard to ignore," says Gendreau.

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Gendreau said that the incumbent party losing seats and the stock market rallying seem to go hand-in-hand during the midterm elections, but it has little to do with voters preferring Republicans over Democrats, or whether or not the incumbent party loses control of the Senate or the House. He said the mid-term elections affect the markets in two major ways:

Mid-term elections generally create gridlock, which usually moves markets higher. Gendreau said the cliché that the market likes gridlock often proves true because, "There is a more even balance of power between the executive and the legislative branch, and that means compromises are more likely...or at least one party's dominating legislative agenda is not as likely."

He suggests gridlock moves more legislators to the center, which can get more economic proposals to jump-start the economy passed, keeping markets happy.

Election outcomes take the risk out of the market. Gendreau said that since corporations don't know the outcome prior to elections, this establishes a "risk premium" in the market that can cause companies to act more conservatively, which can affect earnings. Once the risk is removed, dividends tend to go down and price-to-earnings ratios go up. Valuations increase.

"The market hates uncertainty – that we know – but once the elections are resolved one way or the other, that uncertainty comes out of the market and the market goes up," said Gendreau.

The Dow has already been climbing in anticipation of the midterm elections, a trend Gendreau said was consistent in all the elections he studied. According to his research, the market has always rallied at least 30 days before the midterm elections as the market begins to anticipate the outcomes. This year, the market began rallying in September when economic reports were positive enough to refute fears of a double-dip recession. For investors, Gendreau said that could mean "the post election bounce would be a little weaker because a lot of it would have already occurred before the election."

If the post midterm election rally doesn't produce the average 8.5% gains in 90 days, investors can still look forward to the 10% gains Gendreau's prior research forecasts for the third year of a president's term. Even more optimistically, DailyFinance reported that Jeffrey Hirsch, editor-in-chief of the Stock Trader's Almanac suggests an even bigger windfall during the third year of a presidency -- an average 50% gain from the market low in the midterm year to the market high in the year before the presidential election.

So for investors who have been fed up with Washington politics over the last few years, perhaps the historic potential for stock market gains in 2011 are the closest thing to a bailout the politicians will ever offer.

"Buy call options on the S&P 500 -- that's what I would do," Gendreau said. "But if that's a bit much for most investors, the best thing you can do is go long and stay long."