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How Stocks React in an Election Year

A president's second year is usually not very favorable, and the market has risen, on average just 0.4%. That's when a president often looks to enact tougher policies that can often restrain growth, knowing that several years remain before voters will respond to the new set of policies. Year No. 2 is often characterized by higher taxes, closed loopholes, and vetoed pork-barrel spending. Think of Ronald Reagan's second term, when he agreed to a series of tax hikes in 1986. He would never have done so if his party had been faced with an imminent presidential election. That's why markets have historically been flat in the second year of a presidential term.

Of course, Washington has been so gridlocked that only a few bits of legislation were passed in 2010. Perhaps because of that gridlock, the S&P 500 managed to move up to 1140, good for a 9% gain.

The market usually rises about 15% in the third year of a presidential cycle, as the president typically looks to push through a series of economy-stimulating moves ahead of election season. In this instance, gridlock has not been helpful as it created Armageddon scenarios in the eyes of investors. As of now, we're looking at a flat year for the S&P 500. Add the three years together, and the S&P 500 has actually dropped about 3%.

So to recap, we had two years of solid outperformance and one year of underperformance. Perhaps the fourth year of the cycle will prove to be more advantageous. Indeed, the final year of a cycle tends to deliver 4% gains, and the fact that the S&P 500 is already up around 11% from the end of September can be seen as an offset to the prior three year's underperformance. Still, it may be prudent to trim expectations for the coming three quarters.

Nevertheless, certain sectors can be clear beneficiaries of the fourth year of the cycle. For example, media firms such as broadcasters, advertising agencies and even -- dare we say -- print publications tend to see a big uptick in spending as campaign funds get spent on the candidates.

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