(MONEY Magazine) – History tells us that the two years leading up to a presidential election are usually the best of times for small investors. And, at least until recently, these past two years were no exception. Stocks usually have their peak gains in the year before an election year, with the Dow Jones industrials rising 14.1% on average. In 1991, the Dow topped that, rising a stunning 20%, thanks to a spectacular 10% spurt late in December. And the Dow continued to show solid gains earlier this year. At its all-time high of 3413 in June, the index was ahead nearly 8%. But the broader market is nowhere as buoyant as the Dow numbers suggest. And many experts see stocks weakening in 1993. Such a downturn would be entirely consistent with the historical pattern for years following presidential elections. As most small investors know only too well, the stock market's overall performance has turned spotty. In fact, about half of all stocks have declined at least 30% from their 12-month highs. Moreover, the forces that power the market before a presidential election are running out of steam. Here's the historical pattern, according to Ned Davis Research in Venice, Fla.: -- In the 23 election years since 1900, the Dow has gained an average of 7.8%. -- By contrast, in the 15 years in which the party in power won, stocks rose almost double that, or 13.9%. The best year was 1928, when stocks rallied 46.9% in anticipation of Republican Herbert Hoover's landslide against Democrat Alfred Smith. -- But in the eight years when the incumbent party lost, stocks fell an average of 2.8%. As Election Day nears, investors get increasingly jittery if they sense that the incumbent party is headed for defeat. So measuring from the second party convention to Election Day: -- The index fell 1.7% on average in years in which the party in power lost, not counting the exceptional year of 1932, when Franklin Delano Roosevelt's prospective victory over a truly failed president -- Herbert Hoover -- pushed the Dow to a 45.5% gain. -- By contrast, when the incumbent party won, the Dow gained an average of 8.2%. Assuming history repeats itself, investors could see stocks sink by year-end if President Bush meets the grim fate that the public opinion polls foretell. And if that happens, don't be shocked to see stocks plunge as much as 15% or so. No matter how you think the election will come out, there is one final statistic that should make any small investor take a cold-eyed look at his or her holdings: -- In the years following a presidential election, stocks earned less than 3%, on average, regardless of who won. The best postelection year was 1933, with a 66.7% gain, following Roosevelt's defeat of Hoover. The worst, down 28.7%, came only four years later when Roosevelt beat Republican Alfred Landon. All told, the historical data suggest that the next 12 months will be a time for extreme caution. If you need more convincing, just consider the fact that the Federal Reserve is running out of tricks. With the dollar in a tailspin, the Fed can't afford to keep cutting interest rates. And low rates have been the props holding up the market. Therefore, your best strategy is to consider taking profits in stocks where you have gains of 30% or more. And if you're buying, focus on undervalued issues. We profile six such stocks in Wall Street on page 83 that have already declined 30% or more from their 12-month highs, despite solid prospects for the coming year. For people with less than $10,000 to invest, the Fund Watch column on page 59 discusses 10 top-performing funds that are favored by consultants to corporate pension managers. Safe, solid funds -- the kind you'll need if next year conforms to history.

BOX:

THE ECONOMY -- The economy will grow at a 2% to 3% rate over the next 12 months, and interest rates could begin creeping up after the November election.

STOCKS -- Between now and year-end, stocks aren't likely to advance more than 5% to 3450 on the Dow. On the other hand, they could easily drop 15% to 2800.

BONDS -- Now that interest rates are probably near their low point, long-term bonds are bad bets for further price gains.