Smart Investing Moves in a Mid-term Election Year

March 7, 2014— -- The stock market will likely be robust again this year, but with some key differences from 2013. If history is any guide, uncertainty from the mid-term (mid-presidential term) congressional election will create volatility that follows a familiar pattern.

While stocks are widely expected to perform well in 2014 measured by Dow Jones Industrial Average, you should strap in for what will probably be an up-and-down ride this year. But don’t be resigned to the role of a passive, white-knuckled passenger. There are ways to profit from the roller coaster.

In a typical year the market rallies through April, takes a vacation from May to about November (as the saying goes, many investors sell in May and go away), and then finishes off the year with rallies in November and December.

Mid-term election years tend to be different. In the typical mid-term year since World War II, there has been a weak January (with an average 3 percent drop), followed by a spring spurt with a rally through the end of April. Then there’s typically a rough summer and September that erases gains. Once the outcomes of the November election become more predictable, the market tends to kick into gear again in October, advancing to finish the year with decent gains.

Consistent with this pattern, this year we had the January pullback. Next, expect the market to warm up with the weather, with at least one rally by June, followed by a choppy summer and a great fourth quarter.

Historically, the party not in the White House has tended to outperform the sitting president’s party in mid-term elections. Low approval ratings for President Obama may make it hard for the Democrats to hold on to some of their seats. Virtually all political experts predict that the Republicans will keep control of the House, and some have outlined electoral scenarios that would give the GOP a majority in the Senate.

Of course, at this point, the outcome of the November election is anybody’s guess. Yet there are ways to position your portfolio for the outcome without taking a lot of risk. And as far as mid-term election-year volatility is concerned, there are ways to profit from history’s repeating itself.

Here are a few moves to consider:

• Anticipate industrial momentum. Republican gains in Congress would be expected to result in a more business-friendly posture toward U.S. corporations, potentially aiding domestic heavy-industrial stocks, which are already benefiting from a sharp uptrend in U.S. manufacturing. Says Schwab investment strategist Liz Ann Sonders, “We are at an inflection point. For the first time in post–World War II history, U.S. manufacturing is up three years in a row.”

If a more business-friendly Congress increases this momentum, earnings of small- and mid-cap companies in this category (which have more growth potential than larger, mature corporations) would probably increase, delivering gains to investors in value funds and exchange-traded funds (ETFs) in this space. One mutual fund that seeks to gain from this trend is American Industrial Renaissance Trust, offered by First Trust.

Even without the benefits of a more Republican Congress, however, industrial gains will probably continue from existing momentum.

• Be sanguine about domestic energy. Even a more Republican House might not chant “Drill, baby, drill,” but it would be more inclined than Democrats to ease barriers to domestic production. This would help returns of investments like PowerShares S&P Energy Portfolio ETF (PSCE) and iShares U.S. Oil & Gas Exploration & Production ETF (IEO).

But without Republican seat gains, domestic energy is by no means doomed. Democrats have emphasized domestic production to reduce dependence on foreign oil, though with less enthusiasm for removing barriers.

• Surf the mid-term wave cycle on a beta board. Start by distinguishing exciting stocks from boring ones. By exciting, I mean stocks with high beta — a stock’s potential volatility, gauged by the tendency of its price to rise and fall with market swings. Often, you want to avoid this kind of excitement because volatility can punish returns. But if market volatility follows its normal mid-term election-year pattern, you can use this to your advantage.

A study by Richard Bernstein Advisors shows that since 1986, the current S&P 500 with the highest beta have historically low forward P/E ratios (anticipated price compared with earnings, a classic measure of future estimated value), so they are cheap. Those with low beta have historically high forward P/Es, indicating overvaluation. The PowerShares S&P 500 High Beta Portfolio fund (SPHB) holds 100 of the highest-beta stocks in this index. To exploit the typical market cycle of mid-term election years, consider buying a fund like this now before the spring spike, selling it at the end of April before the summer doldrums and then buying it again in early October.

• Expect things to get ugly. Given the level of nasty rhetoric between the two parties in recent years, this prospect is pretty likely. But as always, there’s the question of how much the nastiness—and the government gridlock it may bring before the election—might goose market volatility as measured by the Chicago Board Options Exchange Volatility Index (or VIX). Various ETFs, based on future contracts, go up with the VIX. So these investments can be helpful as tactical trading tools. To limit risk, be sure to keep these trading commitments extremely short-term — no longer than days or weeks.

These moves can make you a better dancer in a 2014 market ball that will be anything but a waltz fest — more like a break-dancing contest. You may see it this way when you’re spinning on your head with your feet in the air, but market returns this year will be good. If the market follows the historical mid-term election pattern, you can harness political winds and reduce their drag on your portfolio.

Dave Sheaff Gilreath is a founding principal of Sheaff Brock Investment Advisors LLC. He has more than 30 years of experience in the financial services industry, beginning with Bache Halsey Stuart Shields and later Morgan Stanley/Dean Witter. At Sheaff Brock, he shares responsibility for setting investment policy, asset allocation and security selection for the company's managed accounts. He also consults with the clients on portfolio construction. Gilreath received his Certified Financial Planner® (CFP) designation in 1984. He attended Miami University in Oxford, Ohio, where he earned a B.S. degree.

Any opinions expressed are solely those of the author and not of ABC News.