Politics may not be something traders want to be concerned with, but it is a factor they should be aware of. Political pundits expect this to be a close election, perhaps similar to the nail-biter we saw in 2000. That year, the SPDR Dow Jones Industrial Average (NYSE: DIA) fell more than 15% between the beginning of September and the election.#-ad_banner-#

Other election years have also seen declines over this time frame, and traders should be aware that a pullback could develop at any time based on election history, as shown by an indicator developed from that history. This indicator is nonpartisan and applies to presidents of either party.

The Presidential Cycle is widely followed because there is some logic to support the idea that stocks will move based on how much time there is before an election. Under this theory, we tend to see the worst stock market returns in any president’s first two years as they take unpopular actions like increasing taxes or cutting spending. By acting early, it is possible that traders (and voters) will forget about the pain they feel if the actions lead to longer-term growth.

The best year for the stock market is usually the third year of the term, when the actions taken in the first years are leading to improvements in the economy. The fourth year, an election year, is marked by uncertainty and has historically been the second best year of the cycle, but the gains are not distributed evenly throughout the year.

To create an indicator based on this theory, we can average the returns for each year of the cycle and plot that average performance on a chart. For example, 2012 would be the fourth year of the cycle, so we would average 2008, 2004, 2000 and so on, using data as far back as we’d like. This will allow us to see what the average year looks like.

For the Presidential Cycle, I start with data from 1936, which is the year the 20th Amendment moved the start date of the president’s term to January from March. Prior to 1936, the extended delay from the November election to the March inauguration could have an impact on policy and economic actions, changing the pattern of the cycle. Ignoring that earlier time frame focuses the indicator on conditions more like what we face now rather than using data that is irrelevant.

Between now and the election, the cycle forecasts a lower stock market using data for the Dow Jones Industrial Average (DJIA). The daily chart of that index is shown below to offer as much detail as possible and use the maximum amount of data that is available. ETFs have much shorter trading histories and many of the newer ETFs will have a four-year cycle performance that is heavily influenced by the 2008 bear market.

That 2008 bear market contributes to the pattern seen in the cycle of PowerShares QQQ (Nasdaq: QQQ), an ETF that tracks the high-tech stocks in the Nasdaq 100 index. According to the Presidential Cycle, a stock market decline into electionday should be expected in QQQ and we could see the ETF struggle through the first quarter. This ETF has declined significantly in the first three months of every president’s first year since 1993.

Similar patterns are seen in other stock market indexes. The Presidential Cycle is not an indicator that should be used as a stand-alone trading strategy. But it is an indicator that is worth paying attention to.

Action to Take –> Now might be a good time to consider tightening stops and taking sell signals if they develop. It could also be a time to prepare for a market decline that, based on history, is likely to develop over the next few months. 

This article originally appeared on TradingAuthority.com:

Indicator Warns Traders to Prepare for a Market Drop