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Do Stocks Hate Congress?

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History suggests that better times are ahead as Congress recesses.

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A correction cometh.

So says Tom McClellan of The McClellan Market Report in his morning missive on Friday. He notes that participation in the advance is quietly diminishing.

The daily total of NYSE stocks making new 52-week highs, he points out, has been declining since peaking at 470 three days ago.

"This is not a huge divergence like the sort that was evident at the final top in October 2007, but even a small divergence from prices like this one can be a precursor to a meaningful correction within the uptrend," the technician says.

McClellan emphasizes that small divergences like these are not the ones that lead to bear markets lasting months but rather, he writes, to the sorts of annoying little corrections that give uptrends their texture, which is what he is expecting this time.

McClellan says the correction ought to get itself finished up on or about March 22, with a rally then commencing around that bottom date. One significant reason, he notes: Congress goes on its Easter recess after Friday, March 26.

Why in the world should investors care about when our lawmakers bolt out of the Beltway?

McClellan is referring here to the so-called "Congressional Effect." Specifically, academics have found that the stock market performs better when Congress isn't in session.

In March 2006, professors Michael Ferguson of the University of Cincinnati and Hugh Douglas Witte of the University of Missouri at Columbia wrote about this strong link between Congressional activity and stock market returns.

The profs found that since 1897, the year after the Dow Jones Industrial Average launched, 90% of gains came on days when Congress was out of session.

Here is another way to think about the relationship: The professors presented cumulative returns for strategies that invest $1 in the DJIA when either Congress is in session or when it is out of session and invest in cash otherwise.

The "Out-of-Session" strategy invests in the market index on days Congress isn't in session and in cash when Congress is in session. Conversely, the "In-Session" strategy invests in the market index on days Congress is in session and in cash on days Congress is out of session.

The result: For the DJIA, the cumulative returns since 1897 were more than 100 times greater ($216 vs. $2) for the Out strategy.

Check out the study for yourself here.

There is a rational explanation for all this, say the professors: When Congress is in session, uncertainty exists about whether the tax and regulatory constraints that publicly traded firms confront will be altered.
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No positions in stocks mentioned.
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