Sarah Palin's on the Cover of Newsweek but It's Harry Truman's Market

Last Updated Jul 15, 2011 2:17 PM EDT

Sarah Palin's latest appearance on the cover of Newsweek and the circus surrounding Michele Bachmann's presidential aspirations almost made us forget that historically the stock market loves this part of the political cycle.

Regardless of who wins the Republican nomination, the third year of the presidential cycle has in the past been pretty great for stocks. Since 1951 the S&P 500 has produced an average gain of 18.3 percent during a president's third year in office, according to economist Ed Yardeni, the bullishly prescient president of Yardeni Research. (He actually called the market's exact intraday bottom back in March 2009.)

Yardeni has been tracking the S&P 500's performance in the third year of the presidential cycle and so far the prognosis is very good -- but not outstanding. It turns out we're in a Harry Truman market. See the chart, courtesy of Dr. Ed's blog, below:


What this chart says is that relative to the previous 15 comparable years of this political cycle, the market is most closely tracking the Harry Truman market of 1951, according to Yardeni. "If it continues to do so, then the S&P 500 should be up to 1410 by the end of August and to 1465 by the end of the year," he writes.

Gumming this prediction up a bit is legendary investor Jeremy Grantham's take on the cycle this time around. The chief investment strategist at Boston-based money manager GMO is also a big believer in the "Year 3" effect -- but he cautions that it's tracing a different pattern now. Administrations do what it takes to get re-elected, like counting on the sometimes "dangerous" powers of the Federal Reserve, Grantham says. Unfortunately, it looks like the Fed may have already shot its wad.

"Nowhere is this power [of the Fed] more clearly revealed than in the ease with which it can move asset prices, particularly stock prices, and nowhere is this revealed more clearly than in Year 3 of the Presidential Cycle," writes Grantham in a recent letter to clients. The catch is that because the Fed dumped QE2 on top of an essentially zero-interest rate policy last Fall, the Year 3 effect started early, or back in October 2010.

Throw in the added uncertainties of a weak economy, the Japan disaster, the euro zone mess (among other shocks), and it's possible all "the normal Year 3 exceptional performance may have been delivered already," Grantham says. The market might very well move higher throughout the summer, but then end the year with a thud.

More optimistically, if the Year 3 effect continues apace as Yardeni's chart predicts, the market will have produced a gain of 16.5 percent for 2011. True, that's worse than the average gain of 18.3 percent since 1951, but considering the almost unprecedented level of economic uncertainty right now -- and Grantham's very credible concerns -- we'll take it. Give 'em Hell, Harry!


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    Dan Burrows, a veteran of Aol's DailyFinance, SmartMoney and MarketWatch from Dow Jones, covers the markets and economy with an eye toward investing for the long haul.

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