Historically, the third year of a president’s term can be relied on to deliver juicy returns in the stock market, as Washington races to spruce up the economy ahead of the president’s re-election campaign.

In fact, the S&P 500 has soared an average of 17% during the term’s third year since 1945, about three times as much as the next best year in the four-year cycle, according to S&P Equity Research.

However, the sluggish economic recovery, high unemployment and soaring deficits present serious challenges to the markets in 2011, President Barack Obama’s third year in office.

Given those obstacles, many market watchers believe stocks will continue the trend of rallying in a White House’s third year, but they believe the markets will fail to live up to their historical track record.

“Instead of history saying it will be a great year, we think it will be a good year, at best,” said Sam Stovall, chief investment strategist at S&P Equity Research.

It’s been nearly a given that Wall Street will rally in the third year of a presidential term, closing higher 94% of the time since World War II, Stovall notes.

“It’s because investors anticipate that the party in power wants to stay in power and will try to put through whatever stimulative powers they can to make the voters feel good when they go back to the polls,” said Stovall.

Stocks have performed very well under Obama as the U.S. avoided a depression, rescued big banks like Citigroup (NYSE:C) and saved General Motors. 

Since Obama took office in January 2009, the S&P 500 is up about 40%, with 91% of its stocks advancing. The Nasdaq Composite, led by Apple’s (NASDAQ:AAPL) 270% surge, has soared 64% under Obama.

Stocks Face 2011 Headwinds

Yet some believe those gains will be cut into, or at least much more muted, during 2011 due to a number of factors.

First, the outlook for stimulus is bleak. The Federal Reserve has already cut interest rates to near zero and given the unpopularity of the Obama administration’s $787 billion stimulus package and the GOP’s sweeping takeover of the House of Representatives, Congress is highly unlikely to increase spending. 

“That’s not going to happen,” said Douglas Holtz-Eakin, a top economic adviser to Sen. John McCain during his 2008 presidential run and former director of the Congressional Budget Office.

In fact, many believe Congress will (and should) lower spending to fight record-high deficits. 

At the same time, the economic is in a “half-speed recovery” from the Great Recession, says Stovall, with the gross domestic product growing just 1.7% in the second quarter and 2.0% last quarter. The unemployment rate remains stubbornly high, rising from 7.7% when Obama took office during the depths of the downturn, to 9.6% in September.

And due in part to the aforementioned bailouts and big legislative reforms, the total public debt outstanding in the U.S. has jumped 28% under Obama, to a record $13.56 trillion.

Divided Congress: Bullish or Bearish?

It’s not clear if the gridlock in Washington that the mid-term election produced will be as bullish of a catalyst as so many believe.

Since 1945, the S&P 500 under a split Congress has performed only one-third as well as it has when one party controls Congress and the White House, Stovall notes.

“If the current government is not able to come together and address the serious short- and long-term economic problems facing the country, these problems will almost certainly escalate,” Bob Doll, chief equity strategist at BlackRock (NYSE:BLK), wrote in a note. He pointed to the “still-weak” economy, credit-related issues, deflationary pressures, structural imbalances and the expiring Bush tax cuts.

On the other hand, Goldman Sachs said in a recent report that the S&P 500 has gained 11% during the 12 months following the six change-of-control elections since 1950, including two presidential elections.

Holtz-Eakin believes this election “will be one of the best pieces of news for Barack Obama in a while” because “it will save him from his and his party’s worst impulses.”

Bullish Factors for Stocks

While the markets clearly face some economic and fiscal headwinds, analysts believe there is enough going in Wall Street’s favor to allow stocks to continue to make headway.

Equity analysts remain largely bullish on stocks, calling for S&P 500 earnings per share to rise 14% in 2011 to $94 a share, building on 2010’s expected gain of 45%.

Also, by some metrics, stocks are still cheap. Stovall says the S&P 500 is trading at just 15 times operating results of the past four quarters, a 17% discount to the average trailing PE ratio of the past 22 years. From a GAAP perspective, stocks are trading at 17 times trailing results, a 23% discount to the 22-year average.

“Valuations still look compelling,” said Art Hogan, chief market strategist at Jefferies & Co.

Of course, historical models for a bullish third year in office could always be proven false by unforeseen circumstances like geopolitical developments or a new crisis in the economy, such as the foreclosure mess.

“I’m a little hesitant to put too much on these predictions as opposed to random chance,” said Dean Baker, co-director of the Center for Economic Policy and Research, a progressive think tank.

For example, the first Gulf War and higher oil prices helped fuel the Dow Jones Industrial Average’s 20.3% rally in 1991 under President George H.W. Bush. Likewise, the beginning of the tech bubble helped drive the blue chips up 33.45% in 1995, President Bill Clinton’s third year in office. 

In any case, forecasters see a decent, but not great, 2011 for stocks. S&P Equity Research has a 12-month target of 1270 on the S&P 500, a rise of 6.5% from current levels.

“Have a good exposure to equities, but don’t go overboard,” said Stovall.