The Stock Market Rally and the Election

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

By Doug Roberts, chief investment strategist for Channel Capital Research.

NEW YORK ( TheStreet) -- The recent stock market rally occurred in a presidential election year. Is this a coincidence, or is there some relationship here? Does the battle for the White House have an impact on the financial markets?

What does this mean for the future of the market? This is the subject of this month's commentary.

Economic Improvement Slows!

Economic numbers have improved in 2012. The biggest news continues to be in the employment numbers. Nonfarm payrolls increased by only 120,000, far short of expectations for 200,000 and only half of February's 240,000. The payroll numbers have been decreasing since January.

The unemployment rate decreased to 8.2%, but the hours in the average workweek decreased as well.

Several experts are attributing this to an exceptionally mild winter. This may have led some industries, such as construction, to begin projects this winter that normally would not have begun until spring.

Consumers may have used the mild winter to begin spring shopping a bit early. This may also have contributed to the economic improvement.

In contrast to this year, the winter last year was quite severe, postponing many projects until late in the spring season. The combination of these two opposite geothermal events may have made economic comparisons between last year and this year deceptively positive.

We will soon find out whether the economic improvement is simply a seasonal anomaly or real improvement. If it is primarily seasonal, we should see the comparisons to last year continue to run into resistance.

Bonus Depreciation Again!

As we have mentioned previously, many have forgotten the government stimulus program and its effects, which are still being felt today. It may have contributed to the recent increase in manufacturing.

The "Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010" allowed for full 100% depreciation of new purchases made in 2011. This decreases to 50% depreciation in 2012. This was a tremendous incentive for people to place orders last year. Because of uncertainty and procrastination, many people waited until the last minute.

This also includes large vehicles used strictly for business purposes. This could account for the robust sales recently experienced by auto companies, especially of SUVs.

Even though the bonus depreciation benefit has greatly been reduced in 2012, this may result in continued strength for manufacturing this year. Again, the question becomes whether these are purchases that are borrowed from future years.

This still does not appear to be the beginning of the "V"-shaped recovery that everyone has been forecasting.

The Election Year Cycle

The performance of the stock market usually has a pattern that tracks the four-year term of the president. Bear markets and recessions usually occur during the first two years of the president's term. Bull markets and recoveries usually happen during the last two years, leading up to the presidential election.

This is not just a statistical anomaly. There is a logical reason behind this pattern. All presidents usually want to get re-elected or want another individual from the same political party as successor to protect their legacies.

This pattern seems to be even stronger when a president is up for re-election. Bear markets or crashes in the last two years of the President's term occurred during final terms of Presidents Reagan, Clinton and Bush. Besides these exceptions, the last two years of a presidents' terms have been positive since World War II

The President and the Stock Market

There is a correlation between the president's approval rating with the performance of the S&P 500.

This means the president has a huge incentive to keep the stock market in good condition at least until the election.

Lender and Spender of Last Resort

Recent economic reports definitely indicate a recovery, but as I have mentioned, the improvement has been marginal at best relative to the fiscal and monetary stimulus and the amount of time that it has taken for this to occur. Although these numbers are still in positive territory, many people are still uncertain about the future and believe that without further government intervention, we could slip back into a recession.

The improvement in the economy has been quite limited with only a small segment of the population participating, leading to what we have described as "two economies." One has seen a rebound, but the other has not really experienced much improvement. The one that has experienced a rebound has been largely due to the rebound in the equity market. This creates even more incentives for the president to do everything in his power to maintain a positive performance by the S&P 500.

This has really not borne any resemblance to the "V"-shaped recovery that many were forecasting. It is much closer to the jagged "U"-shaped economic recovery that we predicted.

I have said previously that this is quite different from earlier recoveries. In most of those earlier cases, government stimulus merely "primed the pump" until the private sector took over. Now, government remains "the lender and spender of last resort."

Prospects for Fiscal Stimulus

As we mentioned earlier in this commentary, we believe much of the economic rebound may be due to accelerated depreciation found in the "Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010." This was passed when the president's party controlled both houses of Congress.

It was much easier for the president to pass fiscal stimulus to assist in his re-election in this environment. In the current environment in which the Democrats only control the Senate and in which the Republicans want to do everything possible to prevent President Obama's re-election, the prospects for additional "official" fiscal stimulus are quite limited.

However, there are forms of "unofficial" fiscal stimulus that fall primarily under the control of the president. Increased gas prices have acted as a tax on the consumer. Thus, an immediate decrease in prices could act as a tax cut, a form of fiscal stimulus. There has been discussion that the president may unilaterally decide to release supplies from the Strategic Petroleum Reserve to achieve this.

There is also discussion that the government must force a write-down of delinquent mortgages to offer relief to homeowners. Since Fannie Mae ( FNMA) and Freddie Mac ( FMCC) account for a substantial portion of mortgages outstanding, the president could utilize his position to force these entities to adopt his position.

Prospects for Monetary Stimulus

Recent statements by Federal Reserve Chairman Ben Bernanke and actions by the Fed indicate some form of QE3 may not be immediate but that it remains a possibility:
  • Rates would continue to remain low even if there is some improvement in the economy as long as unemployment remains elevated.
  • The long-term inflation target would be 2%, but short-term spikes in inflation may be tolerated.
  • If the economy deteriorates, alternative forms of easing will be considered.
  • Chairman Bernanke has also indicated that long-term fiscal reform is necessary to prevent a huge increase in the national debt but cautioned against removing fiscal stimulus too quickly in our current weak economy, despite any indications of recovery.
  • Chairman Bernanke mentioned that he would protect the U.S. from any problems associated with the European financial crisis.
  • The composition of the Federal Open Market Committee (FOMC) has changed. The FOMC's most hawkish members, Narayana Kocherlakota of Minneapolis, Richard Fisher of Dallas, and Charles Plosser of Philadelphia, all lost their votes. These were the dissenters. Their replacements, with the exception of Jeffrey Lacker of Richmond, are all considered to be more dovish.

Chairman Bernanke is also preoccupied with the mistakes made by the Federal Reserve during the Great Depression in tightening prematurely. He would rather be responsible for 3%-4% inflation as opposed to 15%-20% unemployment.

Is Liquidity the Key to the Battle for Re-Election?

Liquidity is usually created by the Federal Reserve along with the other central banks as well as other government programs.

This increases the price of risky assets, otherwise known in Wall Street terms as the "Risk Trade." The Fed effectively has forced people to invest in riskier assets for the near future in order to generate a return on their money.

In our previous commentary, we divided the total return on the S&P 500 1988-2012 by the total return on Treasury Bonds:

The S&P 500 peaked in 1999 and has been in a secular bear market since then. It has experienced periodic cyclical bull markets since that point. After 9/11, we experienced a cyclical bull market driven by an injection of Fed liquidity. However, more liquidity injections were required until a new cyclical bull market began in 2003 driven by the rise of the shadow banking system. This was a multiyear cyclical bull that last until the subprime crisis of 2007.

Quantitative Easing and Cyclical Bull Markets

During the last several years, we have experienced short cyclical bull markets driven by quantitative easing. We find that the fallies coincide well with quantitative easing programs.

We also find that the recent rally seems to have begun with Fed programs last year, such as "Operation Twist," to infuse liquidity into the system.

At the time, many pundits were saying that the central banks and the governments were powerless to stop the downward spiral due to financial crisis in Europe. Bearish sentiment was rising to elevated levels. Then, just as it appeared the markets were going to crash, coordinated central bank intervention was announced.

The Federal Reserve, the European Central Bank, the Bank of England, the Swiss National Bank, the Bank of Canada and the Bank of Japan announced "coordinated actions to enhance their capacity to provide liquidity to the global financial system... These central banks have agreed to lower the pricing on the existing temporary U.S. dollar liquidity swap arrangements by 50 basis points so that the new rate will be the U.S. dollar overnight index swap (OIS) rate plus 50 basis points." Separately, the Bank of China eased as well.

The length of this cyclical bull market may be dependent upon whether the recent Fed actions represent the beginning of QE3. No one may actually call it by this name. However, the effects may still be the same.

Threats Still Remain

Problems in Europe still remain. There has been no real solution to the crisis. There is still also a real danger that a country such as Greece could decide to abandon the euro. This could cause a severe dislocation in the worldwide banking system.

The Arab Spring continues to be an Islamic Winter. There is a real possibility of a radical Islamic government in Egypt, and questions about abrogating its current peace treaty with Israel. The current military government will not allow this to happen. There is a possibility of a civil war in Egypt.

Iran is also continuing with its nuclear program despite U.S. opposition. If it continues on schedule, it is possible that it could pass the point of no return within the year. There are rumors that the Israeli government may be planning a strike on Iran to prevent this.

Thus far, these situations appear to be contained. However, the potential for the outbreak of hostility still remains.

Central Bank Neutralization of Threats!

Systemic bank uncertainty lay with the subprime crisis in 2007 and currently lies with Europe and the Mideast. There was limited transparency regarding the financial institutions holding this debt. In 2007, this led to a domino effect that spread through all the world's financial markets.

In 2007, the Federal Reserve and other global central banks began to adopt a looser monetary policy in response to the subprime mortgage crisis. They assumed that the standard monetary response would be effective in containing the crisis and preventing the domino effect described above.

Initially, it appeared to be working. This is what triggered the rally in the latter half of 2007. Then additional problems, such as the bankruptcy of Lehman Brothers, became difficult to contain using standard monetary policy tools.

Monetary policy will need to be loosened even further, including possibly a massive intervention to at least postpone financial Armageddon to a later date. Nothing will be truly resolved, but the game of "kick the can down the road" can continue.

What is the Threshold of Pain in a Presidential Election Year?

If there is not a major shock to the global financial system such as the ones described above, the rally should continue. We have reached the spring highs of 2011 in some indices even without a government stimulus package.

With regard to the rest of 2012, the strength of the rally will depend upon government stimulus. Based upon Fed Chairman Bernanke's recent comments, we may still be in a trading range of 1100-1400 on the S&P 500. If QE3 or something similar is being enacted, we could exceed the 2007 highs.

Any of the potential shocks described above could damage the financial system quite substantially. As long as the Fed and the government are able to counteract these threats successfully, the situation may not deteriorate.

These threats are significant. If the Fed makes a mistake similar to those of 1931 or 1987, serious problems can occur. The U.S. equity markets are particularly vulnerable because many of the sources and solutions to these problems are largely outside our control.

Many of our Twin Foundations strategies have turned positive last year. Our U.S. Equity Trend Indicator turned negative during the summer but turned positive in January of this year. It missed some of the rally but is allowing us to participate.