Stumbling S&P 500 Reaching Worst Stretch of U.S. Election Cycle

The political calendar is working against investors.

Already hit by concerns valuations are too high just as the Federal Reserve withdraws stimulus, the equity market is entering what has historically been the worst period of the presidential cycle, the stretch before midterm elections. The Standard & Poor’s 500 Index has lost 2.5 percent and 0.3 percent on average in the second and third quarters of years like this one, according to data compiled by S&P Capital IQ and Bloomberg. Stocks in the benchmark gauge are about one percentage point away from matching such a loss after posting the biggest weekly slide since 2012.

While the pattern may be coincidental, it makes sense to Malcolm Polley of Stewart Capital Advisors LLC, who says uncertainty comes to a head as the president’s policies are debated. It’s being exacerbated in 2014 after winter weather made it impossible to tell whether gross domestic product is stagnating and investors speculated how soon Fed policy makers will tighten, he said.

“The economic picture is cloudy, the interest rate picture is cloudy, the valuation picture is cloudy,” Polley, who helps oversee $1.2 billion as president and chief investment officer of Stewart Capital in Indiana, Pennsylvania, said in an April 7 telephone interview. “Couple that with what I call the political silly season. You’ve really got a recipe for a difficult market.”

Equity Slump

Stocks have fallen more often before midterm elections. In the average year, the S&P 500 has declined in the second and third quarter 38 percent of the time. That compares with about 60 percent of the time in a midterm year, according to data compiled by Bloomberg. Since the end of World War II, the president’s party has given up seats in the House in almost 90 percent of midterm votes.

The last time a reelected president faced midterm elections was in 2006, when President George W. Bush was in office. The S&P 500 retreated as much as 7.7 percent in the second quarter before Democrats swept control of the House and Senate.

Investors shun equities in the months before elections as they wait for clarity on the direction of U.S. policy, Sam Stovall, chief equity strategist at S&P in New York, said by phone on March 31. House Republicans have unveiled plans to repeal President Barack Obama’s health-care law and balance the federal budget in 10 years, while the president is working on legislation to eliminate salary disparities between men and women.

Uncertainty Element

“The market in general can deal with good news, it can deal with bad news, but it doesn’t do well with uncertainty,” Drew Nordlicht, managing director and partner at HighTower Advisors LLC in San Diego, said in an April 3 phone interview. The firm oversees $22 billion. “Midterm elections usually breathe in an element of uncertainty.”

In 2010, when Obama’s tax policy and overhauls on health- care and financial system drew criticism as anti-business, the S&P 500 tumbled as much as 16 percent from April through July. Democrats later lost their House majority.

During Bill Clinton’s second term in 1998, the S&P 500 declined 7.7 percent over the six months through September as Republicans called for an impeachment inquiry on the president. Voters rejected the focus on Clinton’s affair with former White House intern Monica Lewinsky, giving Democrats a surprise win. That’s the first time since 1934 that the White House’s party picked up seats in the House during a midterm election.

Worst Return

The worst return came in 1974, when the S&P 500 plunged 32 percent in the middle six months amid the Watergate scandal and President Richard Nixon’s resignation. That year, Republicans lost seats in both houses of Congress.

After a 30 percent surge in the S&P 500 last year, stock- market gains are slowing down. Since the end of March, companies whose earnings are least tied to economic growth have risen the most. Utilities are up about 2.6 percent, while financial and health-care shares are down more than 3 percent.

Stock valuations that some investors consider excessive have contributed to the retreat this month. The price-earnings ratio for the S&P 500 has risen 24 percent in the past two years to 17, data compiled by Bloomberg show.

Investors shouldn’t make buy or sell stocks based on election cycles, said Howard Ward, the chief investment officer for growth equity at Gamco Investors Inc. He said his firm focuses on economic and company fundamentals to make investment decisions.

Historical Pattern

“You cannot assume the historical pattern will be repeated,” Ward wrote in an e-mail. Rye, New York-based Gamco oversees about $47 billion. “It is a short-term event.”

Even if Republicans win control of the Senate, there will be a limited change in Washington’s power structure and that bodes well for stocks, according to Jim McDonald, chief investment strategist at Chicago-based Northern Trust Corp. They need to gain six seats to saddle Obama with both chambers of Congress in opposition control for his last two years in office.

“Politicians won’t be able to do very much,” McDonald said by phone on April 3. “The market likes certainty and the certainty will be very little new legislation.”

Media stocks stand to benefit regardless of which party wins as candidates pour cash into newspaper and television ads, according to Ned Davis Research Group. The industry has outperformed consumer companies by about four percentage points in the seven months before an election since 1986, a November study by the Venice, Florida-based research firm showed.

Ad Stocks

When Obama ran for re-election against Republican Mitt Romney in 2012, the S&P 500 Media Index surged 37 percent, almost triple the gain in the broader gauge.

Utility shares are a good bet given the likelihood of bigger stock-market swings this year, said David Kotok, chairman and chief investment officer of Cumberland Advisors Inc. While concern about the economy and slowing profit growth may drag down the S&P 500, the retreat will be temporary, he said.

Analysts forecast profits at S&P 500 companies decreased 0.9 percent in the first quarter, as the severe winter weather hurt sales from housing to retailers, estimates compiled by Bloomberg show. In January, they expected a 6.6 percent rise.

“We’re positioned for an ongoing bull market with volatile correction,” Kotok, whose firm manages $2 billion, said in a telephone interview on April 8. “We have, at the moment, some directions which aren’t very clear and they pile on top of the scheduled midterm. That’s why we’ll have more volatility.”