It's the Fed, Stupid - TheStreet

Updated from 6:59 a.m. EDT

If you're planning to vote for President George W. Bush because you believe the market responds better to the Republican Party's pro-business philosophy, or if you're siding with challenger Sen. John Kerry because recent years would indicate that stocks outperform under Democrats, you're wasting your vote, says a recent study.

"Don't Worry About the Election, Just Watch the Fed," published in the

Journal of Portfolio Management

, found that contrary to popular opinion, the political party of our presidents since 1937 has had a negligible impact on the financial markets.

The study's three authors also give the heave-ho to the gridlock theory that investments do better when the president and Congress are from different parties and therefore can't muck things up too badly.

So what really moves the markets?

The

Federal Reserve Board

, hands down, says study co-author Robert R. Johnson, Ph.D., CFA (chartered financial analyst) and executive vice president of the CFA Institute in Charlottesville, Va. His co-authors are Scott B. Beyer and Gerald R. Jensen, both professors of finance at Northern Illinois University in DeKalb.

When the FOMC tightens money policy, as it has three times since late June, investors should hunker down and expect lower market returns, cautions Johnson.

Past research has shown that stocks tend to perform better under Democratic administrations, and bonds have their heydays under Republicans. But the returns, when considered along with the actions of the Federal Reserve, show a different, more dramatic pattern, especially since the 1960s when the Fed took on a pronounced role in managing the economy.

"Fed policy dominates in determining securities returns," says Johnson, who notes that the study is the first to consider the political party of the president, gridlock and the Fed influence all in one (see the chart below). "The Fed relationship to securities is some of the most striking findings I've seen."

When the Fed is in an expansive mode, regardless of which political party is in the White House, the

S&P 500

index tends to earn 10% more than when the Fed is in a restrictive mode. And small-cap stocks soar 20% higher.

"The other factors (presidential party and gridlock) are not only secondary," says Johnson, "they are miniscule. Too much blame always ascribes to the president for the economy."

For example, he says, former President Bill Clinton walked into the best situation imaginable, what everyone assumed was a recession but was the start of an unprecedented economic boom. On the other hand, President George W. Bush took office as the Clinton good times were ending and almost immediately faced the harsh economic realities that followed the 9/11 terrorist attacks.

It's not that the election or presidential policies have no effect on the markets. They do, says Johnson. And both parties can enact pro-business or tax-friendly policies that stimulate them. It's just that the Fed plots the overall course.

Richard A. Weiss, chief investment officer with City National Bank in Beverly Hills, Calif., who oversees more than $6 billion in client assets, read the study and agrees with its conclusion that the election should be only a "minor distraction" for investors.

Because he gives many speeches and gets audience feedback, Weiss has learned that during presidential election seasons many people feel the need to make a market move in anticipation. But he urges them to let the feeling pass.

"To think that you have some inside scoop on who's going to win the election and that it's not already priced into the market is foolhardy," he says. "If you fear Kerry will win, for God's sake don't sell stocks based on that fear."

Weiss suggests that those who want to profit from the election might rather let off steam by betting directly through online exchanges such as

TradeSports and the real money futures market, the

Iowa Electronic Markets, where contracts will be paid off on the basis of the winner of the 2004 presidential election. That market is run by the University of Iowa Henry B. Tippie College of Business. "Fortunately," says Weiss, "the markets are one of the races we can bet on all the horses."

How the markets behave is incredibly consistent with whether the Fed is loosening credit or tightening it, says Johnson.

In recent years, it followed an expansive policy that pushed interest rates to a four-decade low, and that helped fuel an enormous stock market rally in 2003. Since it became clear that the central bank would raise rates sooner than expected -- and then raised the fed funds rate from 1% to 1.50% since June, both stocks and long-term bonds have been incredibly volatile. All three major indices are well off their early 2004 highs, while the 10-year Treasury is back above 4%.

"Here's the bad news," says Johnson. "We're in a restrictive time right now. Investors need to adjust their expectations to lower-than-average, certainly to single-digit, returns. Not only are returns low, they're very volatile."

He said that cyclical stocks are highly sensitive to the Fed cycles, so a stock like

Gap

(GPS) - Get Report

, which depends on discretionary income, might not fare as well as a grocer selling staples such as

Safeway

(SWY)

.

Also likely to suffer in a tightening cycle are small-cap stocks, which have had a great run in recent years, partly because they will find it more difficult to get access to capital to run and grow their businesses.

No sector performs particularly well in a restrictive Fed mode, says Johnson, but defensive stocks such as gas and utilities are likely to be hit less hard. Investors, Johnson says, would be well-advised to keep their income-earning investments short term now, in T-bills (typically 13- and 26-week maturities) and short-term bond funds, but invest them in mid-term maturities and long-term maturities (10-year bonds) during the Fed's expansive periods.

It used to be that U.S. investors could look overseas to get better results when domestic investments were faring poorly, says Johnson. But the global market has created such interdependency, and U.S. monetary policy is so powerful, that that is no longer true.

Before joining TheStreet.com, Ann Perry was the personal finance columnist for The San Diego Union-Tribune. She is the author of "The Wise Inheritor: A Guide to Managing, Investing and Enjoying Your Inheritance" (Broadway Books, 2003). She has a B.A. in English and Communications from Stanford University and a master's degree from the Columbia University School of Journalism. She can be reached at

Ann.Perry@thestreet.com.