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In early July I quantified the very unique tendency of the S&P 500 (NYSEARCA:SPY) to deliver strongly positive returns in the three months (between July-end and October-end) before a Presidential election featuring an incumbent (see "The Positive Trade When Incumbent Presidents Run For Re-Election"). The analysis was motivated by S&P Capital IQ's Sam Stovall who interpreted this effect in the opposite way: positive returns during this time period are predictive of an incumbent victory. It turns out Presidential incumbents tend to win re-election in the U.S., so I disagreed with Stovall's interpretation. I next emphasized the attractiveness of this pre-election trade by noting that the maximum drawdown over this period is quite mild compared to the average 3-month period between July-end and October-end. The pre-election trade featuring an incumbent worked again this year, but these gains were short-lived. It turns out that the gains from the pre-election trade rarely last; the sugar-high is not sticky.

The 2012 pre-election trade delivered a 2.4% gain with a maximum 1.0% drawdown - not bad, but certainly not great. This performance ranks in the middle of the pack for the post-World War II period.

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Performance of the S&P 500 From July-End to October-End During Election Years With A Running Incumbent

At one point, the S&P 500 gained as much as 6.3%. The top came the day after the Federal reserve announced QE3 and turned out to be the first peak of a triple top. The chart below covers the entire rally off the June lows. On July 31st, the S&P 500 happened to close a few points above the May, 2011 closing high; the index lost all its pre-election gains just as it broke down below its 200-day moving average (DMA).

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The S&P 500 has already lost all its gains from the pre-election trade

Source: FreeStockCharts.com

By the second day after the election, all the gains from the pre-election trade disappeared. The downtrend that led to this loss developed throughout October, highlighted by a key technical failure at the 50DMA. The 100 total calendar days from July-end to the day all gains disappeared, places this year's pre-election trade in a special place. Of the ten re-election campaigns since World War II, this year's is the only one to deliver positive gains during the pre-election period only to go negative right after the election. As noted above, three of the ten pre-election periods delivered negative performance by October-end.

A wide gulf exists between the bottom performers and the rest of the pre-election periods. The next three performers lasted between 270 and 399 days. The pre-election trade for 2004 delivered returns as modest as this year's but with a much larger drawdown. The gains lasted until the financial crisis of 2008 finally obliterated years of hard-earned gains. The pre-election trades of 1984 and 1996 are the best performers as the market has yet to return those gains. Note well from the chart above that these two periods also delivered the highest gains and had no drawdown.

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Duration** of Gains from the Pre-Election Trade With A Running Incumbent

Source for price performance charts: Prices from Yahoo!Finance; election info from Wikipedia

* 1984 and 1996 are empty because the gains from these periods continue to last.
** I measure "duration" from July-end of a given re-election year to the day the S&P 500 first closes at or below its July-end price AFTER the pre-election period ends. This method of calculation means that the durations for the three pre-election periods that delivered negative performance - 1956, 1976, and 1992 - essentially measure the number of calendar days in the pre-election period.

So, of the ten pre-election trades featuring incumbents, only two produced lasting gains and only four lasted longer than one year. Four ended either right before the election or right after the election. The positive trade when incumbent Presidents run for re-election rarely lasts.

The U.S. will not have another Presidential election featuring an incumbent for at least another eight years, so we have a very long time to wait to put this trade to the test again. However, a lesson I learned from following this trade is that the stock market tends to deliver multiple opportunities to make a trade. Note well that it took a major secular bull market (from 1982 to 2000) to generate pre-election trades with staying power. Until such a monster bull market re-emerges, these kinds of contextual trades should continue to offer unique profit-making opportunities.

Be careful out there!

Source: The Positive Trade When Incumbent Presidents Run For Re-Election Rarely Lasts