How to Trade the Midterm Elections

MILLBURN, N.J. (TheStreet) -- The election of Republican Scott Brown to fill the late Ted Kennedy's U.S. Senate seat set off a political tidal wave in Washington. The Senate Democrats no longer have the 60 votes necessary to assure cloture (a vote to end debate), putting health care legislation in jeopardy and raising the stakes for upcoming midterm congressional elections, which will likely be heating up much earlier than usual.

In 2008, I wrote about how to trade a presidential election. With the 2010 midterm elections on our horizon, let's investigate whether we can come up with some guidelines for trading those.

Note that I have accumulated data for the S&P 500 going back to 1950, a midterm election year. Thus, 2009 (a post-presidential year) represented the end of the 15th presidential election cycle in my database.

The Presidential election cycle is comprised of four distinct years:

1. Year Before Presidential Election
2. Presidential Election Year
3. Post-Presidential Election Year
4. Midterm Election Year

First, let's take a look at how each of these years and the constituent quarters has performed on average in each of the election cycle years:

Furthermore, we can look at how each of the months has performed on average by year in the election cycle:

So, armed with this data, can we trade the midterm election year? I believe we can, and here are three ways to do it.

1. Sell in May and Go Away

You might have heard the old maxim "Sell in May and go away." But if you look at the monthly average returns, the only historically negative months are February and September. So "Sell in May and go away" might be little more than an old wives' tale -- except when it comes to the midterm election year.

The second and third quarters of the midterm election year -- and in particular the months of May, June, August and September -- tend to be down months. Thus, it may make sense to sell or sell short the SPX at the end of April and wait until the end of September to cover your shorts.