Who Cares About Gridlock?

¹²Who Cares About Gridlock?
Stocks Appear To Shrug Off Certain Mid-Term Elections

By Mark Hulbert, Marketwatch | 5 October 2010

CHAPEL HILL, NC (MarketWatch)— October is when some powerful seasonal winds begin blowing in the stock market's sails. And, with the possible exception of small-cap stocks, those winds appear to be so powerful that they are likely to continue blowing regardless of how much additional gridlock is produced by the upcoming mid-term elections.

Polling For Profit

October is known for its jumpy markets, and this year with elections around the corner, the stakes are even higher. The seasonal pattern to which I refer above is year three of the four-year Presidential Election Year Cycle. According to many adherents, who define that cycle in terms of fiscal years beginning with the fourth quarter, the third year in this case has just begun (on Oct. 1, in fact).

It's helpful to begin this discussion by summarizing the empirical support for the Presidential Election Year Cycle. I follow the lead of many researchers and focus only on the years since 1945. It was only after the Great Depression and World War II that the federal government grew to dominate the economy to anywhere near the extent it does today.

As has been well documented by others, year three is by far the best for the stock market. The Dow Jones Industrial Average (DJIA) in third years since 1945 has produced an average gain of 24.7%. [[Note: It's actually been up ~50% in those third years, from the second calendar year trough to the third calendar year peak, averaged from 1917!: normxxx]]. The comparable returns for years one, two and four, in contrast, are 4.0%, 1.9%, and 3.3%, respectively.

How do mid-term elections affect this so-called Third Year Effect, and in particular the presence or absence of political gridlock in Washington? It's a fair question, since mid-term elections always occur about one month into the third year. And the 2010 mid-term election that is slated to take next month is virtually guaranteed to produce more gridlock.

Fortunately, the presence or absence of gridlock does not appear to have a big impact on the strength of the third-year effect— as you can see from the accompanying table. (I followed the lead of past researchers in defining 'gridlock' to exist whenever different political parties were in control of the presidency and either house of Congress.)

Gridlock prevails before mid-term elections	Gridlock prevails after mid-term elections	Dow's average return in 3rd year that follows	# instances since 1945
No	No	16.9%	4
No	Yes	19.0%	4
Yes	No	22.2%	1
Yes	Yes	29.3%	7

The row of the table most relevant to the current situation is the second one, since it is almost certain in the upcoming elections that the Republican Party will gain control of at least one house of Congress. Notice that the Dow Jones Industrial Average (DJIA) produced an average gain of 19.0% in the four prior mid-term elections since 1945 that similarly ushered in an increase in gridlock. That's not appreciably different than the 24.7% average return for all third years since 1945 (and not significant at the 95% confidence level that statisticians often use to determine if a pattern is genuine). From this I conclude that the imminent increase in gridlock in Washington is not a reason, in and of itself, to expect the Third Year Effect to be any weaker than otherwise.

Small Caps During Third Years

The only exception to this overall pattern comes for stocks of the smallest-capitalization companies, which appear to be particularly vulnerable to an increase in political gridlock in Washington. On average since 1945, for example, the smallest-cap stocks have tended to do even better than the large-caps during third years. In fact, the difference during such years between the smallest-cap decile and the 10% of stocks with the largest market caps is an impressive 9.3%. (I relied on the definitions of these deciles employed by Eugene Fama and Ken French, finance professors at the University of Chicago and Dartmouth, respectively.)

Following the four mid-term elections since 1945 that resulted in increased political gridlock, however, the situation was reversed: In those four cases, on average, the average small cap actually lagged the average large cap— by 2%, in fact. Playing the Third Year Effect strictly by the numbers, therefore, and given the increase in gridlock that will be the almost-certain outcome of the mid-term elections, you therefore would want to begin favoring large-cap stocks over small-caps.