UPCOMING ELECTION SHOULD WORRY INVESTORS

By David Schwartz 17:00 19- Nov -2009

The recent rally is likely to run out of steam. Shares often do not do very well in the run-up to close elections.

My expectations for the next few months have become increasingly negative. Several factors have caused this shift in opinion. They include the size of the recent rally and the upcoming election.

UK shares rose 29 per cent since the last minor sell-off ended in July. At their recent high point, prices advanced by a whopping 53 per cent since the bull market began in March. I view both figures as too much, too soon.

Rallies like this one warrant a yellow warning flag in my book.

The tail-end of the rally was triggered by the US third-quarter earnings season which just ended. The news was positive which helped to drive share prices up.  But the good earnings news is now in the price and shares are unlikely to rise much further until fresh positive news emerges. In the interim, experience warns me to beware of a partial pullback after a steep rally.

Another worrying point is that much of the profit improvement turned in by US corporations was due to cost-cutting, not sales growth. Unfortunately, you can only fire your staff once. In other words, cost-cutting is often a one-off quick fix. Without revenue growth to sweeten performance investors might be disappointed with profit growth in the next round of earnings statements.

The upcoming UK election is also worth thinking about. Political experts expect it to be held about six months from now.

History provides some useful lessons about elections. Decisive wins are virtually always preceded by big stock market gains in the six-month run-up to Election Day, regardless of who wins.  But small majorities are often associated with losses.

The difference between the two groups is striking. There were five elections in the last half-century when the winner’s majority was fewer than 20 MPs. Shares fell in the six-month run-up four times.  The average decline was 15 per cent

Nine other elections saw the winner emerge with a majority of at least 20 MPs.  Shares rose eight times in the preceding six months by an average of 15 per cent.

Investors clearly do a fine job of anticipating future election results. I find this worrying because the Tories are currently expected to win the next election by a small margin.  Some experts even warn they might not win a majority. This could lead to government paralysis.

The six-month election count-down just began or will soon do so. I believe the odds favour a share price dip. When it starts and how big it will be is anyone’s guess. 

Might this election be an exception to the rule?  So far, signs suggest not. The current government’s main focus is on getting re-elected, not making the best decision to solve a major economic crisis.

The Conservatives may or may not have the stomach to make difficult decisions if they win the next election. We must wait and see. But for the moment, they probably will not talk too tough, except in very broad terms, because they too do not want to frighten potential voters.

The bottom line is that we should expect a period of political aimlessness and drift in the next six months. This raises the odds of stock market weakness.