How do elections affect the stock market? Open any handbook on market timing, and you'll see suggestions on how you can improve your investing returns on specific days -- right before year-end holidays, during certain planetary alignments, when a team with the letter "R" in its name wins the World Series. Among these tidbits is how you can benefit by basing your buying and selling on the presidential election cycle.
But we Fools say that when it comes to investing, pay attention to the bulls and the bears, not the donkeys and elephants. Timing the market is for the birds.
Several studies purportedly show that presidential elections do indeed affect the stock market and that the best times to own stocks are the two years before an election. Conversely, stocks apparently do not do as well during the first two years of a presidential term. One study, for example, shows that from 1941 to 1995, every bear market but one has occurred in the first or second year of a president's term; none have occurred during the last year, right before an election.
There are several theories for this. One is that the party in office is juicing the economy in the years before the election, but the market must face the music once the election is over. Another is that investors are banking on the promises candidates make and then pulling out of the market once those promises aren't immediately fulfilled. A third hypothesis is that the economy stalls because it takes a new president one to two years to find his way out of the Lincoln bedroom and to the White House parking lot.
So knowing that the markets supposedly react to the presidential election cycle, what should you do?
Absolutely nothing, Fool.
First off, these are just tendencies, which may be nothing more than coincidences. The problem with basing investment decisions on such data is the many exceptions to the rule. For example, if you sold your stock before the first two years of a presidential term, you would have missed out on a 28-percent return in the S&P 500 in 1989 (the first George Bush's second year in office) and an almost 30-percent return in 1997 (the second year of Clinton's second term). On the other hand, if you invested solely in the years before an election, this wouldn't have saved you from "Black Monday" -- Oct. 19, 1987 -- when the Dow plunged 22.6 percent in one day.
It's important to remember what ultimately moves the market: supply and demand. Just like the prices of pork bellies, oil, and Beanie Babies, the price of a share of a company will go up if there are more buyers than sellers, and the opposite happens if there is a swell of sellers. For the vast majority of investors, the election cycle is not foremost in their minds during the buy/sell decision process.