Stocks and Election Years -- What's the Connection?

What is all this January talk?

There's the "January effect" and the "January barometer" and the "first five days means this" and yada yada...

Stock watchers love nothing more than reading the tea leaves, especially at the beginning of a new year. And after a disappointing 2011, they are looking for any sign that the market is headed up.

The Magic 8-Ball
An election year only adds to the divining about the future of the market and the presidency. S&P 500 returns in the three months leading up to a presidential election have predicted the victor in the last seven elections, and the degree of the change seems to correlate with the margin of victory in the election. If the market was up between the end of July and the end of October, voters kept the ruling party in office; if it was down, they elected the opposing candidate.

Investors can apply this pattern conversely. If polls this summer show Barack Obama is likely to win, you might expect a market rally up to the election. Of course, improved economic news would certainly help him to victory, which would benefit the market as well. Overall, elections appear to be good for stocks as the market has risen in 13 of the past 15 presidential election years. This year, the tight polling seems to mirror the flat market we've had over the past year.

Some analysts talk of a January barometer, the predictive powers of the first month of the year, which they claim is even stronger in an election year. A positive January in an election year has predicted a full-year gain in the S&P 500 all eight times it's happened since 1945 with an average gain of 16%. A negative first month predicted a full-year decline 56% of the time with an average loss of 3.9%.

One study by Pepperdine University business professor Marshall Nickles found that stock market cycles tend to last about four years, tracking the election cycle with bottoms two years into the presidential term and peaks at the end of the election year. Nickles explained that through the administration's control over fiscal and monetary policy, the president can "pump up" the economy before an election through an economic stimulus, which results in inflation that must be addressed in the beginning of the next presidential term leading to a bear market. In today's political climate, however, another stimulus is unlikely. Nickles' study was also published in 2004 before the financial crisis that came during an election year, contrary to his model's projection.

The good news
If you're the type of investor who needs a better reason than election correlations to feel confident, take heed in the fact that the S&P 500's (INDEX: ^GSPC) P/E ratio dipped to a quarter-end low this past October not seen since 1989.Earnings per share for the index are at record highs, surpassing pre-recession figures, and are expected to continue rising. Despite high unemployment at home, the debt crisis in Europe and worries about a slowdown in China, corporate earnings are marching higher. Earnings per share for the index is projected to increase about 11% from last September to September 2012, and dividends per share have also grown by more than 20% since bottoming in 2009.

Those positive signs could favor cyclical stocks such as Alcoa (NYS: AA) and Caterpillar (NYS: CAT) , two Dow stocks expecting earnings-per-share growth of more than 40% this year, whose prospects would only increase with an improving economy and investor sentiment. I also think Corning (NYS: GLW) , along with Alcoa, could recover nicely this year, as they both trade near their 2009 low with P/E ratios of 6.6 and 9.9, respectively. Corning's Gorilla Glass, which will benefit from growing smartphone sales and could become more prevalent in TVs, makes it an even more alluring investment to me.

Of course, the presidential election isn't the only major event taking place this year. With the Olympics set for London this summer, I expect another strong performance from Nike (NYS: NKE) in 2012, which has outperformed the S&P 500 by an average of 24.5% in the past five Summer Olympics years. The Olympics serve as a showcase for sport and the apparel brands that support it, and Nike is the market leader in the United Kingdom. A new Nike concept store near the Olympic grounds will further help promote this global brand.

With the election, the Olympics, and some strong manufacturing reports to start the year, 2012 looks more promising than 2011. We can help you get your new year started off on the right investing foot with this report on a stock our experts are calling "The Motley Fool's Top Stock for 2012." The report is free, but it won't be here for long. You can read it now by clicking right here.

At the time this article was published Fool contributor Jeremy Bowman owns shares of Nike but holds no other positions in the companies in this article. Motley Fool newsletter services have recommended buying shares of Corning and Nike. Motley Fool newsletter services have recommended creating a diagonal call position in Nike. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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