By Jack Hough
The first years of presidential terms have historically been disappointing for stock investors.
That’s one of those patterns that easily could be a statistical fluke. But this election season, there is more than historical returns to give pause. Cautious investors might want to take some money off the table.
Over the past half century, during the first and second calendar years following presidential elections, the Standard & Poor’s 500-stock index (SNC:SPX) has returned an average of 2.6% a year, adjusted for inflation. During the third and fourth years, it has returned 11.6% a year.
In a working paper, economist Marshall Nickles at Pepperdine University suggests interest rates might play a role. Over the past 50 years, the federal funds rate has been about half a percentage point lower, on average, during the second two years of presidential cycles than during the first two. Falling interest rates can spur stock returns.
But Congress makes new laws, not the president, and the Federal Reserve sets interest-rate policy. Without a clearer cause-and-effect relationship, investors should look beyond election cycles to market fundamentals for guidance.
Those fundamentals look challenging. The mighty stock rally of the past few years has been powered in large part by equally mighty growth in corporate earnings. But that is changing.
Last quarter, earnings for the S&P 500 increased 8.4% from a year earlier. But they would have risen just 3% if not for Bank of America’s (NYSE:BAC) swing from a massive loss to a modest profit, according to Gregory Harrison, an analyst at Thomson Reuters.
This quarter, S&P 500 earnings are expected to decline year over year for the first time since 2009.
Earnings growth could accelerate if the economy picks up. But the economy expanded at an annualized pace of just 1.7% during the second quarter, down from 2% in the first and 4.1% in the fourth quarter of 2011. And the coming election could pave the way for even slower growth in the short term, no matter which party wins.
That’s because the president and Congress in 2013 will come under intense political pressure to do something about America’s mounting debt. That means higher taxes, lower government spending or both.
Any choice could subtract from growth in the near term, says Tim Steffen, director of financial planning at Milwaukee investment firm Robert W. Baird. “Someone’s going to get hurt,” he says.
Higher taxes could cut into the spending power of shoppers, denting profits for retailers, manufacturers, travel-and-entertainment companies and more. Government spending cuts could hurt profits for health-care companies, defense contractors, technology consultants and other groups that sell to Washington.
None of this is reason to flee stocks altogether, not least because the short-term pain of deficit reduction should yield longer-term stability and growth. But cautious investors might want to turn temporarily from their usual asset mix to a more cautious one holding, for example, 50% in stocks instead of their usual 60%.
They might even save a bit on taxes in the process. Investors who generate long-term capital gains by selling this year will pay either 15% tax or zero, depending on income. Next year, those temporary rates are set to rise to 20% and 10%, respectively.
Many investors expect Congress to extend the lower rates, like it did two years ago. Maybe, but the safest bet is that the deal isn’t going to get any better than it is now.
Investors should sell only those positions they were thinking about trimming anyway, advises Baird’s Steffen. “Don’t let the tax tail wag the investment dog,” he says.
To find candidates for selling, look to traditional sources of high dividend yields: utilities and companies that make consumer staples like packaged food. They are 10% and 21% more expensive than the index relative to this year’s earnings estimates, respectively, in part because meager bond yields have set off a scramble for income.
Where to put the cash you raise selling stocks? Consider bank money-market accounts. They are highly liquid and federally insured, and the rates often are higher than those available on short-term Treasurys or money-market mutual funds offered by investment companies.
Bankrate.com lists a handful of banks that pay at least 1% on money-market accounts. That isn’t the kind of return an investor wants to lock in for long, especially because inflation has historically gobbled about 3% of purchasing power per year. But the recent inflation rate has been 1.4% over the year through June and less than zero since the end of Marchone symptom of slowing economic growth.
After next year, investors who have raised some extra cash might consider reinvesting it. Of course, there isn’t any way to know for sure whether they will buy shares at lower or higher prices than today. But they will have turned unknown tax rates for future capital gains into this year’s known one, and reduced portfolio risk during what could prove a tumultuous period for stocks.
Election year cycles aside, that looks like a pretty good deal.
