There has been a lot of ink spilled about how the stock market performs during Presidential election years generally leaning to why investors should be fully invested to the hilt.  The current election year, with just three months remaining, has certainly played out to historical norms with the markets advancing on expectations of continued government interventions even as economic and fundamentals deteriorate.  To wit Bespoke Investment Group wrote back in July: "We have highlighted the similarities between this year and prior Presidential Election years numerous times. Most recently, in early July we noted the fact that based on the historical pattern, the S&P 500 could see a modest pullback in mid-July coinciding with the kick-off of earnings season. Sure enough, the market saw some choppiness about a week and a half ago and subsequently rebounded in the middle of last week. Holding to the historical pattern, that rebound came right at the same time that the market historically sees its summer low.  If the pattern continues, the S&P 500 could be set up for a nice rally to end the Summer. Will it hold? Only time will tell, but if the historical pattern has worked so far, what's to stop it from continuing?"

What is to stop it from continuing?  That is an interesting question.  Deteriorating economics, weakening earnings, a resurgence of the Eurozone crisis, a dead-locked debate in Congress on the "fiscal cliff" or an outbreak in the Middle East are just a few of the issues that could derail the market advance from here.  However, with the Federal Reserve now injecting the financial markets with liquidity, we will just assume that the rest of this year plays out according to historical norms for the moment as I want to focus on next year?

How does the market generally perform the year following a Presidential election period.  The table shows the annual returns of the Dow Jones Industrial Average during the four years of the Presidential cycle going back to 1833.  While Presidential election years have averaged 5.1% historically - the year following the election has been much less exuberant averaging only 1.9%.  More importantly, the probability of an up year during an election year has been 65.1% whereas that probability plummets to just 45.4% in the following year.  

The problem with the majority of these types of analysis, however, is that it excludes the impact of secular market periods.  For example - if I wanted to maximize my investment return I would simply invest during the Pre-election year periods and average a 10.44% return.  The problem with that analysis, which is what all of the mainstream analysis entails, is that you can live for one hundred years, or longer, in order to garner the average return.  Unfortunately, while pharmaceutical companies have figured out ways extend sexual activity for up to 4-hours without needing to seek medical attention; they have yet to discover the secret to immortality.  Therefore, when looking at historical data it is important to keep it within the context of the secular period within which you are investing. 

The chart below shows the secular periods of the S&P 500 (inflation adjusted) going back to 1871.  Since most investors have on average about 20 years to actually save and invest for retirement it is key to understand within which secular cycle they are investing as returns can be vary greatly from the average "long term" return in many cases.

From a longer term perspective it is readily apparent that we are currently engulfed in secular bear market as the debt deleveraging/balance sheet recession continues.  While central banks try to fend off the negative effects of those recessionary forces by injecting the financial systems globally with liquidity, which can skew markets higher temporarily, the fundamental realities of excess credit and leverage will continue weigh on economic growth for years to come.  As the distortions caused by these artificial interventions fade - the reversions will suppress long term returns for investors trapped within the current secular cycle.

However, in order to discern what 2013 might look like, regardless of whom is elected President, we must begin by looking at the average return of all post-election years going back to 1961 for the S&P 500 (Federal Reserve weekly data starting in 1957). 

The chart above shows that the markets tend to come out of the gate a bit rocky as the markets await the President's first "100 days" to get a sense of what changes, or lack thereof, there are likely to be.  From that point, until late summer, the market has advanced.  After the seasonal summer weakness passes the markets have continued to push higher into the end of the year.  This is all very normal accordingly to most long term studies.  As noted in the chart above the average return of all post-election years has been 7.5% going back to 1961.

Utilizing this bit of analysis it is quite evident that you should immediately invest all of your assets today to capture the 7.5% return coming next year.  Not so fast.  While the mainstream media, and most Wall Street analysts, would jump on this bit of "bullish" analysis for an attention grabbing headline or to sell you some investment - the analysis is quite flawed.

The table shows the annual returns for each year.  It is clear that some years have definitely skewed the overall average higher with 1961, 1985, 1989, 1997, and 2009.  With the exception of 2009 all of these outsized returns occurred during secular bull market periods where multiples were expanding from very cheap levels as economics and fundamentals improved.  During bear market periods returns have been much lower than the average.

The 2009 post-election year return was much greater than what may have normally been the case as the system was flooded with a variety of government programs to boost economic growth (cash for housing and clunkers), QE programs, and bailouts.

The next chart shows the post-election year average returns broken down by secular bull and bear markets periods.  While the performance of the two periods looks similar in terms of price action - the returns are substantially different with the bull market periods yielding a whopping 20.3% on average versus a small 1.6% return during bear markets.

Yet, even this data is somewhat misleading.  The average return of the bear market periods is skewed by the outsized, artificially induced, rally during 2009 as discussed previously.  In order to get a better analysis of what a more normalized post-election bear market period looks like I have charted the average bear markets returns both including and excluding the 2009 period.

As you can see there is a substantial difference in performance when 2009 is excluded with the average market return dropping from 1.6% to a negative 5.3%.

The important points of this analysis are as follows:

• Be careful of all analysis as it is very easy to manipulate data to give an overly positive, or negative, view which can lead to detrimental investment decision making.
• Long term analysis is fine for discussions, however, understanding how markets perform during secular bull and bear market periods is what drives returns during your specific time horizon.
• We have never before lived in an era of unprecedented and continued market interventions by central banks worldwide.  No one knows for sure whether these monetary actions will work or what the eventual outcomes will be.  If Japan's economy is reflective of the long term effects of government interventions - then that outlook is not a positive one.

One thing that we can be fairly sure of at this point is that the Fed is likely already well on its way to inflating the next asset bubble.  As we discussed recently in "Bernanke's Folly - Part II" - "What is evident is that while QE programs have flooded the excess reserve accounts of Federal Reserve banks there is little evidence that it translates to anything other than higher asset prices and a boost to the profitability of the banks through trading activities. However, these increases in bank liquidity, which are ultimately transformed into proprietary trading activities, is something that we witnessed during the real estate bubble from 2004-2008.

While no two markets are ever the same – in this case, however, the issuance and repackaging of mortgage debt previously supplied massive liquidity to banks. This liquidity was then funneled into proprietary trading operations which drove markets higher. Today, the Fed is buying the mortgage bonds from the major banks in turn providing excess liquidity which again is funneled to proprietary trading desks. The net result is same." 

The importance of this is that the Fed was blind to the asset bubble being built in late 2007-2008 just as they will most likely be blinded by a focus on employment to the exclusion of risks building elsewhere in the system.  Therefore, as an investor looking into 2013 it is important to understand the context within which data is presented.  It can be, in many cases, grossly misleading.  

As investors we have only very limited time frames within which to save and invest which is why it is critically important to understand the which market cycle you are in.  Secular bear markets do tremendous amounts of damage to individuals over time as savings, and investments, fail to accumulate at a pace sustain future purchasing power parity.  As we head into the last leg of 2012 it is important to recognize the many critical issues that will continue to plague the global economy going into 2013.  The continued recession in Europe, unresolved debt and deficit issues for governments, slow economic growth and rising poverty levels are impacting consumption, creating civil and geopolitical unrest and exacerbating the unresolved fiscal issues.

While the markets can certainly do the "unexpected" in the short term, particularly when the governments worldwide are willing to "do anything" to try and prop up the system, the general consensus is that the "unexpected" will be a positive.  However, after two sequential 50% market declines since the turn of the century the real question we need to be asking ourselves is "what if it is not?"