(MONEY Magazine) – Wall Street gets in a lather about the monthly jobs numbers, but the employment report that really preoccupies the market comes once every four years, with the presidential election. Ned Davis has charted market cycles at his independent investment research and advisory firm, Ned Davis Research, since 1980. Using history as a guide, Ned told me in January that this should be a good year for stocks--at least until November.

INSANA: How reliable is the indicator that deals with the presidential election year?

DAVIS: It's pretty good. You can find a few election years that are down, but usually they have special situations. The last one that was down was in 2000, when the bubble burst. Before that, you've got to go all the way back to 1960, which was down 3%. The market was worried about JFK, so the market went down right into the election, and then as soon as he was elected, it went straight up. It had already discounted all the negatives. Election years are not as strong as pre-election years, but they're still up more often than not. Going back into the 1880s, they're up 72.4% of the time; the median gain is about 8%.

Q. What are some of the wrinkles in the market's election-year behavior?

A. The most important distinction occurs between the conventions and the elections. If it looks like the incumbent party's going to win, the market goes straight up, and if it looks like the incumbent party's going to lose, the market gets pretty weak. If you knew then who was going to win, you could make a pretty good little bet there.

Q. Thanks for the heads-up.

A. The median gain if the incumbent party wins is 13.3%. If the incumbent party loses, it's 4.2%. That's using medians, but if you use means, the numbers are even bigger. So it's 13.3% if the incumbent party wins--and that's my best guess for the year.

ONE VOTE FOR GRIDLOCK

Q. There's a lot of talk about which party is better for the stock market. Which combination, with respect to the President and Congress, is the best environment for stocks?

A. When you get into this, you can see that the stock market really does not have a political bias, even though if you took a poll on Wall Street, you'd probably find a vast majority of Republicans. But overall, when a Democratic President has been in office, the market's gone up 7.2% per annum. That's without dividends. And if a Republican's there, it's 3.8%. So the market has actually done much better under Democrats than Republicans. Historically, Democrats have been more stimulative.

And we found that when the President was one party and the Congress was the other, the market did better--particularly a Democratic President and a Republican Congress: 9.6% per annum. So it seems that the market doesn't like radical change, and therefore, when you've got a sort of gridlock, the market is more comfortable.

Q. The market has been enjoying a pretty strong rebound recently. Is it all election-year excitement?

A. The election cycle has something to do with it, but the market has been really extraordinarily strong. I think that's the most favorable thing. We also don't like to fight the Fed, and we think the Fed is going to stay friendly. Even if they raise the Fed funds rates a quarter or a half--and I tend to think they won't this year--I still wouldn't really see that as a major obstacle.

SOBER OPTIMISM

Q. How high would interest rates have to go for you to turn negative on stocks?

A. We think 4.75% on the 10-year note [4.03% in mid-January] would be a problem for the economy and the market.

Q. It's hard to find a market-based indicator that's flashing any warning sign.

A. The sentiment and valuation indicators are mixed. If you look at them on an absolute basis, they're all pretty terrible looking. But relative to interest rates and inflation, they're livable.

Q. You mentioned sentiment. It's hard to find somebody who is unabashedly bearish on the stock market, although for all the bullish signs, you don't hear people talking about stocks the way they did in the late 1990s.

A. No. That was really the big shock for me because all the polls show everybody's bullish, but then these year-end surveys came out and everyone's forecasts are quite modest. In one survey the average forecast for the S&P 500 was 1139 by the end of 2004. Another had the S&P at the end of the year at 1166. That's maybe a 4% or 5% gain. What kind of bullishness is that? The same thing for corporate profits. In the late 1990s people were predicting 15% or 20% gains. People are optimistic, but they seem pretty sober at the same time.

Q. Would any pullback more likely be a correction rather than the resumption of a bear market?

A. Yeah, my guess is we will have a correction. But historically, election years do very well in the second half.

A BULL WITHIN A BEAR

Q. Are we still in a bear market and this is just a correction, or have we begun something new that is a little bit more encouraging than most people think?

A. What's encouraging is that the Fed really looked at the other post-bubble environments and saw that unless you stimulate [the economy] very quickly and very aggressively, you could stay down for a very long period of time. And the Fed had no problem doing that. They have an opportunity to let growth rip for a period of time, and that suggests a pretty good bull market.

But as I look at the huge trade deficit, the consumer debt and the absolute valuations, it suggests to me that it's still a cyclical bull market within a secular [long-term] bear.

Q. Which period in history is most like the one we're in now?

A. My guess is the 1970s. Maybe that was a 1970 bottom last year. We're now running into the 1970-72 period, when the market made all-time highs and then went into the 1973-74 declines. At the time we were going through it...it was pretty difficult to argue that [the '70s] was a long-term negative period, but it turned out to be.

Q. How do you know when to sell in this cyclical bull market?

A. I'm going to wait for the tape to break down and/or the Federal Reserve Board to start raising rates. If all the sentiment indicators turn bearish, that would be a concern as well.

Q. What kind of sector selections would you make in this environment?

A. In the pre-presidential election year, usually you've got a tremendous amount of stimulus, and that tends to help growth stocks. The feeling is that the economy's going to heat up and these stocks are really going to zoom, so information technology, health care, telecom services and materials tend to be the leaders. [See the chart on page 68.] The leadership tends to shift rather dramatically when you get to the election year, and you get much more defensive value-oriented leadership, with the best groups being energy, financials and health care. The best performers in the pre-presidential election year become the worst performers in the election year. Although they gain, they're still among the weakest sectors.

This year technology could stay unexpectedly strong, though, because there is a tax cut for capital expenditures that hits this year but expires next year. If you're going to buy a computer system, the incentive to do it this year is enormous. So you're looking at booming growth in the tech area.