2013 Stock Market Outlook: What History Predicts

Posted 7:00AM 01/01/13

By Tom Sightings

The race doesn’t always go to the swift, goes the old saying. But that’s the way to bet it, replies the savvy gambler.

So it is with the old saying about the stock market. Past performance is no guarantee of future returns. But it still makes sense to look at historical data-because that’s the way to bet it.

Optimism about the economy and the political scene brought strong gains for the stock market in 2012, despite occasional jitters over the so-called fiscal cliff. There are reasons to think the rally will continue through 2013. Europe is getting better. China is stronger. Maybe our own economy will pick up as unemployment goes down, consumers build confidence, and politicians agree to compromise.

But history holds a warning. Research tells us that the stock market tends to follow a presidential cycle. Stock prices go up during a presidential election year like 2012 by an average of about 8 percent. This past election year brought us almost twice that, some 15 percent.

History also tells us that the first year of a new presidential term is often less kind to the stock market. Ned Davis Research ran the numbers long ago and found that stock market returns during the first year of a presidential term (including re-election terms) average only about 5 percent. Gains for the second year are even less, averaging just 4 percent. It’s the third year of a presidential term that produces the biggest gains, averaging 12 percent, and then the fourth year, like 2012, typically tacks on another 8 percent increase. In other words, the last two years of a presidential term produce much stronger gains than the first two years. So unless you think that President Obama will be better than average, 2013 will likely be a lean year.

A study by Marshall Nickles of Pepperdine University reveals a more foreboding future for 2013. Nickles tested data from 1952 through 2000 and found that an investor who bought stocks and held them for the first two years of presidential terms, then sold them, would have made money six times, and lost money seven times. In the end, because the losses were bigger than the gains, the investor would have lost nearly half his money. Compare those results to the investor who bought and held stocks in the second half of presidential terms, then sold on the day the presidents were inaugurated. That investor would have made money every time, for an overall gain of more than 7,000 percent.

Nickles and others caution that while the presidential cycle theory is historically accurate, it does not necessarily predict stock prices. The market is subject to various forces, many of them unforeseeable, and a recognized pattern may not anticipate the next turn in the market.

Still, another report from John Hancock Mutual Funds confirms the observation that the stock market ekes out small gains during a president’s first two years, then goes gangbusters during the president’s second two years. John Hancock puts the chances of a stock-market gain during a presidential election year at 74 percent. But the chances of a gain during the first year of a presidential term fall to 57 percent. And this study calculates an average return of just 4 percent. Now, 57 percent is still better than even odds. But do you want to take a 43 percent risk of losing money in your retirement fund, just to eke out a 4 percent gain?

Of course, there are always exceptions, sometimes big ones. For example, the last time a Democratic president was reelected, in 1996, the market went up a blistering 30 percent the following year.

So another indicator to watch for is the so-called Santa Claus rally. Yale Hirsch of The Stock Trader’s Almanac looked at the last five trading days of the year plus the first two of the new year. Since 1950, those seven days have averaged a 1.5 percent gain in stock prices (an annualized rate of over 50 percent). He also found that this Santa Claus rally often predicts the next year’s market. If the Santa Claus rally arrives on schedule, it’s a good sign. If it doesn’t, then the following year often turns bearish.

Those who ignore history do so at their own peril. To borrow a phrase of another president, Teddy Roosevelt, from over a hundred years ago: As you go into 2013, walk softly, and carry a big cash balance.

Category: Blog