The Volokh Conspiracy

In late August, I began writing a post: “An Optimistic Scenario for the Stock Market and the Economy.” Because of the difficulty (bordering on impossibility) of predicting the stock market, I waited until I saw some evidence of a move up to post my predictions, which I did on September 9, 2010:

Typically, a Democratic majority in the House of Representatives has been bad for the stock market and the economy and Republican control has been good (in the past, I have run, but not published, the numbers back to 1854). The reverse is generally true for the presidency [a Democratic president is good and a Republican president is bad, though the effects are not as consistent as for the House and their sizes depend in part on how far back in time one goes and whether one treats the market as anticipating or lagging presidential turnover].

There have been two switches from Democratic to Republican control of the House since 1950: in the 1994 election and in the 1952 election.

Cumulative returns in the S&P 500 over the two years following the 1994 Republican takeover (1995–96) were 69.8%. (The three-year returns for 1995–97 were a staggering 127.0% [+38%,+23%,+33%].)

Cumulative returns in the S&P 500 over the two years following the 1952 takeover (1953–54) were 54.7%. (The three year returns for 1953–55 were 98.4% [-1%,+56%,+28%], but the Democrats retook the House in the 1954 election.)

Indeed, the best year for the S&P 500 since World War II was 1954 (56.0%), the second year after a Republican takeover of the House. The best year since 1976 was 1995 (38.5%), the year after the last Republican takeover of the House.

So will we get a huge stock market increase this time, as we have the last two times that Republicans have taken the House? Maybe, maybe not. . . .

Ironically, if the Republicans retake the House and the stock market booms as it did after the 1952 and 1994 takeovers, such a strong recovery would greatly increase President Obama’s chances of being re-elected.

So what do I think about the stock market? At the moment at least, I am fully invested in US and foreign stocks and mutual funds — and I hope to remain so over most of the next two years, at least if the Republicans take the House and there are no major new pieces of economy-destroying legislation or EPA regulations.

The first leg of this process has worked out, though I recognize that it might be just a coincidence. The Republicans took the House of Representatives on Tuesday and the S&P 500 is up 10% since September 9 and 16% since the end of August. The stock market this fall had the best September since 1939 (when the European stage of World War II began and, presumably, European money flowed into the safe haven of the US). Small caps had their best September-October run since 1982, the beginning of one of the greatest bull markets in history:

Small cap’s gains in September and October have been the best since 1982 and bode well for an end-of-the-year rally, in the estimation of Bank of America Merrill Lynch. (In the previous five-best September/October stretches of performance, small caps averaged 8.2% in November and December.

For those curious about what happened in the weeks after the 1952 and 1994 takeovers, in 1952 the market moved up sharply for the rest of 1952 before stalling out when the Korean War news weighed heavily on the market. The market bottomed in September 1953 (the Armistice was signed at the end of July) and then exploded to start a huge 2-year expansion. The three-year S&P 500 returns for 1953–55 were 98.4% (-1%,+56%,+28%).

In 1994, the market dropped in November, followed by 8 straight months of very strong stock market gains. The three-year returns for 1995–97 were 127.0% (+38%,+23%,+33%).

I remain very bullish on the stock market, as I was in early September. If quantitative easing (which I think is a bad idea) does indeed weaken the dollar, as Bill Gross has warned that it might, foreign and emerging stocks may be a better place to be than US stocks. I don’t think that cash or Treasury bills are safe against inflation and currency risks. [In other words, the likelihood that you will lose money (measured by purchasing power) in money market or safe fixed investments is very high compared to investing in the stock market, though the chance that you will lose a lot of money, e.g., 30-50%, is higher in the stock market.] If the US government were smart, it wouldn’t be buying US government debt (as the Federal Reserve is doing), but rather it would be locking in today’s low interest rates for generations to come by issuing lots of 30-, 50-, and 100-year bonds, thus making our huge debt less costly for future generations.

If the stock market continues to boom, I would expect the economy to start growing strongly in the spring and the job prospects for our students to improve somewhat by next summer.

For the caveats to this stock market analysis and the very good reasons why I might be wrong, see my September 9 post.

Predicting the stock market is either impossible or extraordinarily difficult, so I generally refrain from doing so — in print. Even apparently successful investors who trade daily or weekly are wrong nearly as often as they are right. So with the caveat that the chances of my being right are at best not appreciably better 50-50, I wanted to share an optimistic scenario for the stock market over the next 2-3 years.

Typically, a Democratic majority in the House of Representatives has been bad for the stock market and the economy and Republican control has been good (in the past, I have run, but not published, the numbers back to 1854). The reverse is generally true for the presidency.

There have been two switches from Democratic to Republican control of the House since 1950: in the 1994 election and in the 1952 election.

Cumulative returns in the S&P 500 over the two years following the 1994 Republican takeover (1995-96) were 69.8%. (The three-year returns for 1995-97 were a staggering 127.0% [+38%,+23%,+33%].)

Cumulative returns in the S&P 500 over the two years following the 1952 takeover (1953-54) were 54.7%. (The three year returns for 1953-55 were 98.4% [-1%,+56%,+28%], but the Democrats retook the House in the 1954 election.)

Indeed, the best year for the S&P 500 since World War II was 1954 (56.0%), the second year after a Republican takeover of the House. The best year since 1976 was 1995 (38.5%), the year after the last Republican takeover of the House.

So will we get a huge stock market increase this time, as we have the last two times that Republicans have taken the House? Maybe, maybe not.

If the Republicans take the House, why might we get a strong stock market?

(1) an end to disastrous new government efforts to stimulate the economy (or at least a significant slow down in such wealth-destroying efforts);

(2) a probable reduction in regulatory uncertainty; and

(3) a reduction in the odds for increased taxes (beyond the expiration of the Bush Tax cuts for those making over $250,000).

A strong stock market and a reduction in regulatory uncertainty would likely lead to robust economic growth — and eventually strong job growth. That would make the world a lot better for our students and our children.

I don’t expect that good economic policy will suddenly start coming out of Washington in 2011, but I do hope that the policies will not get increasingly worse, month by month. Though we will never know, I believe that, if the Federal Reserve and the Bush and Obama Administrations had done little else than lower interest rates, provide liquidity, and temporarily guarantee money market funds, we would have had a brief, sharp recession, followed already by robust GDP growth.

So why might this optimistic 2011-2013 scenario not happen?

(1) the Republicans might not retake the House (the number of pick-ups needed is exceedingly large);

(2) the Republicans might act like the Democrats once they regain control, as they mostly did the last time they held sway;

(3) significant tax rate increases are already scheduled for 2011;

(4) because of tax increases, economic activity may have already been shifted from 2011 to 2010;

(5) a new carbon cap or tax may be imposed either by a lame duck Congress or by the EPA;

(6) regulatory uncertainties persist, especially over health care;

(7) two events (1952, 1994) are not enough to define an effect, especially since if one goes back further in time, this effect is not present. (The two-year returns following prior Republican takeovers of the House averaged just 5.6%.); and

(8) there were special circumstances in the 1953-55 period (end of the Korean War, worldwide post-WW2 boom) and in the 1995-97 period (computer revolution; end of the Cold War and expansion of economic freedom).

Ironically, if the Republicans retake the House and the stock market booms as it did after the 1952 and 1994 takeovers, such a strong recovery would greatly increase President Obama’s chances of being re-elected.

So what do I think about the stock market? At the moment at least, I am fully invested in US and foreign stocks and mutual funds — and I hope to remain so over most of the next two years, at least if the Republicans take the House and there are no major new pieces of economy-destroying legislation or EPA regulations.