We are approaching the third year of the Presidential cycle. This is a four year cycle in the stock market that compares the performance of stocks in each year of a President’s four year term. Intuitively, this cycle has an appealing quality.
It is based on the fact that politicians act like, well, politicians.
Politicians tell stories to explain their plans and to rouse their audience. This has been especially true in the past few years with both the current President and his immediate predecessor often speaking to large and generally friendly crowds.
The Presidential Cycle’s Underlying Theory
The President faces the crowd with a story. That’s not unusual. In politics, the story usually includes a villain who causes a problem that has only one possible solution and your vote will make that solution possible.
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In order for the Presidential cycle to exist, a number of investors must believe the story and it seems many do. For example, the story from one candidate might be that the old President (the villain) has kept the economy from growing by implementing policies (a problem).
That’s a common theme in political stories and is the basis of many Presidential campaigns. To rejuvenate the economy, the challenger will explain, we need to rescind regulations (a solution) and only a new President can implement that solution which is why the candidate needs your vote.
The story behind the Presidential cycle sounds logical and the data shows that stocks tend to underperform in the first two years of a President’s term, the time he needs to implement the solution that addresses the problem his predecessor created.
The Presidential Cycle’s Performance
When the solution is in place, halfway through the term, the economy booms and stock prices soar. This is the story. The data supports the general outline of that story but is a little different.
The data shows that there is in fact a cycle. Year 2 of the cycle, the current year, tends to be below average. Year 3, the upcoming year, tends to be the best performing year of the cycle. Note that in the chart, the cycle year is measured from November 1. That means the time for action is now.
When considering how to act, it’s important to remember that the Presidential cycle might be helped along by the Federal Reserve.
In an effort to appear neutral, the Fed often maintains its current policies in the run up to an election. After the election results are known, the Fed is free from charges of partisanship and can take aggressive actions to implement their desired policies.
That could mean the Fed is maintaining its current posture, for now, but will ease up on its plans for additional rate hikes if the data remains consistent with a need for monetary accommodation.
Trading the Upcoming Cycle
Based on history, a Presidential cycle does seem to exist. On average, stocks move sideways in the first two years of the President’s term, rally sharply in the year before the election (the third year of the term) and post solid gains in the election year.
Similar seasonal patterns have been identified in other global stock markets tied to local election cycles.
“As always, past performance is only an incomplete indication of future performance,” wrote Goldman Sachs’ Jose Ursua noted in a research report. “But certain patterns, especially those that pass a reasonable number of statistical tests, can be useful guides to surfing the electoral wave ahead.”
Ursua listed three reasons why investors should take these cycles seriously:
- First, the political stakes in presidential, parliamentary or legislative elections often translate into changes in policies which can reshape the economic environment.
- Second, the regularity with which elections take place in most countries may give place to cyclical patterns in government and investment behavior.
- Third, elections can markedly increase political and social uncertainty. These three factors have the potential to affect all asset classes, especially equities, given their strong sensitivity to changes in the economic outlook.
In summary, he found:
Our results suggest that, in the US, the first two years of the election cycle tend to coincide with lower equity returns than the last two, with the second year particularly volatile. In the run-up to elections, returns tend to move sideways as a reflection of unresolved uncertainty.
As uncertainty fades, returns tend to bounce back gradually.
We also find that global equity markets tend to reflect the US election cycle, with lower returns in the second year of the cycle and declining volatility thereafter.
In particular, the election cycle in the US helps to explain a sizable fraction of non-US equity returns, both in other developed markets and in emerging markets.
Applying this research to the S&P 500, the chart below shows it is possibly time to consider buying stocks.
This chart shows a general trend. The current point in the cycle is shown with a vertical bar. The past 52 weeks, however, have been stronger than expected and a possible reversal could overwhelm the effects of the cycle.
Conservative investors may want to await the results of the upcoming election before making a commitment. If the Presidential cycle holds and a rally follows the election, there will be time to participate even if the investor waits for the election results to be known.
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