Presidential Election Cycles as a Predictor of the Stock Markets

[Pages:3]Presidential Election Cycles as a Predictor of the Stock Markets

By Michael Binger, CFA - Senior Portfolio Manager

The stock market goes up and down in cycles. Over the years there have been many attempts to correlate the cycle of the stock market to certain events in the world and its economies. Serious market researchers attempt to correlate stock market movements to a variety of economic data in their predictive models. Market technicians will try and correlate price patterns to stock market cycles. But there are also a multitude of offbeat theories in predicting market behavior such as the Super Bowl winner, skirt lengths, aspirin production and moon phase theory. Surely these offbeat theories are pure poppycock, or are they?

The Super Bowl theory is based on whether the National Football Conference (NFC) or the American Football Conference (AFC) wins. If the NFC wins stocks are likely to close up for the year. If the AFC wins the market is more likely to close down for the year. Don't laugh; it's been accurate 82 percent of the time since the first Super Bowl in 1967. I'll bet many quantitative staffs would be duly impressed with an econometric model that had an 82 percent history of success. Over the years this and other theories have had varying degrees of predictive power. The problem with these theories is that most believe no logical reason can be forwarded for why they have worked other than pure coincidence.

Let's look at another popular and timely market theory that seems to have historical precedent. This is the Presidential election cycle and its correlation to stock market returns. Historically, there has been a distinct trend in stock market returns of the different years of the presidential cycle. The theory goes as follows:

Years one and two of the incumbent President's term usually have given us lower than average Standard & Poor's 500 index returns. Year three produces significant outsized returns while year four is again above average. To take this even further, the theory proposes that year two provides the most opportune buying points in the market and late in year four the best selling point. Let's first look at the historical return data before we start to analyze if this is pure coincidence or if there is some merit to this pattern.

Below are the average and median annual returns for the S &P 500 for each year the Presidential cycle dating back to 1900.

Annual Performance of S&P 500 Throughout Presidential Cycle Since 1900

18% 16.46%

16%

14%

12%

10%

8%

7.24%

11.26%

10.39% 7.77%

6% 4.17%

4%

2%

4.31% 2.20%

0% Year 1 of Presidency

Year 2 of Presidency

Year 3 of Presidency

Year 4 of Presidency

Source: Haver Analytics and CIRA - US Equity Strategy

Average Median

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GRADIENT INVESTMENTS, LLC - AN SEC REGISTERED INVESTMENT ADVISOR

I N V E S T M E N T S , L L C 4570 Churchill Street, Suite 200, Shoreview, MN 55126 |

Presidential Election Cycles as a Predictor of the Stock Markets

A clear pattern certainly emerges, but how has this pattern held up in recent decades? Here's a look at the median returns for each of the four years in presidential terms since 1946, or the end of WWII.

Median Stock Market Returns (1946 - 2010)

25%

20%

18.0

15%

10%

6.7

4.3

5%

0% -5% Year 1

-1.2

Year 2

Year 3

Presidential Term Year

Year 4

The return data of the last 100 and 50 years both point to a predictable pattern over history. Finally, let's look at the number of years in which the stock market had a positive return during each year of the presidential cycle.

100% 80% 60% 40%

Percent of Years in which Stock Market Rose (1946 - 2010) 94 81

56 47

20%

0% Year 1

Year 2

Year 3

Presidential Term Year

Year 4

GRADIENT

GRADIENT INVESTMENTS, LLC - AN SEC REGISTERED INVESTMENT ADVISOR

I N V E S T M E N T S , L L C 4570 Churchill Street, Suite 200, Shoreview, MN 55126 |

Presidential Election Cycles as a Predictor of the Stock Markets

Clearly the data points to years one and two producing substandard returns with years three and four being better. If you really want to profit off this theory year three would be the investment choice with median returns around 17 percent and positive returns occurring 94 percent of the time.

Is this presidential election pattern purely coincidence or can we build a case for why these returns emerge. I believe a rational explanation can be put forth for this correlation between politics and the stock market.

The predominant theory for this pattern is that incumbent Presidents want to be reelected. Washington can play an active role in influencing the economy and since most voters tend to vote with their wallets it behooves a President approaching reelection to implement policies that will stimulate the economy and boost the stock market. The administrative branch can do this with fiscal policy (think Keynesian economics) by lowering taxes, increasing spending and curtailing regulation. All of these are generally good for corporate profitability and the stock market. On the flip side, Yale Hirsch of the Stock Trader's Almanac has found that wars, recession and bear markets tend to start or occur in the first half of a Presidents term. The anemic first half, strong second half S&P 500 returns of the Presidential cycle have been fairly predictable and investable over the previous century.

The Presidential cycle stock market theory has historically worked over time, but is certainly not bulletproof every time. We only need to look at George Bush's second term and the first three years of Barak Obama's Presidency to see that the trend is not perfect. Bush's last two years, 2007-2009, gave negative returns while Obama's first two years were strongly positive return periods. This is exactly opposite of what history would tell us, proving that this theory has merit, but like all statistical studies, past predictability is no guarantee of future success.

Since we have been looking at the Presidential term year cycles it would also be interesting to see the correlations between political parties and stock market returns. Who does the general stock market prefer, Democratic or Republican Presidents? The data may surprise you. Over the last 50 years the Dow was up twice as much when Democrats were in office versus Republicans. Over the last 110 years, dating back to 1900, the market still performed better when Democrats

controlled the Oval Office versus Republicans. For Democrats, the Clinton years were really strong, while the George Bush Jr. years of the 2000 decade were fairly weak for the S&P 500.

2012 is an election year. What can we glean from history as to who will win this year? We should all watch the S&P 500 closely between July 31 and Oct. 31. Historically, when this period has a positive return the incumbent has been reelected 89 percent of the time. When this period is negative the incumbent loses 86 percent of the time according to data compiled by the Standard & Poor's. Finally, no modern President has ever been reelected when the unemployment rate is above 7.2%. And we all know where unemployment stands today.

So now that we've reviewed the historical returns related to the Presidential cycle and the politically motivated actions causing them, what investment products can we use to profit from them. Here are some potential suggestions from the Gradient Investments product suite.

Year one and two ? the recently opened Gradient Controlled Volatility Portfolio (CVP) would be an ideal product for the first half of the election cycle since typically these are the most turbulent years according to the thesis. The more conservative Endowment A and B Series would also provide more protection in what has historically been a weaker period for the market.

Year three ? this is the turbo-charged year for returns according to the Presidential cycle theory. We'd want to have maximum exposure to the stock market during this time using Gradient portfolios found in the Endowment Series-E or Gradient 50.

Year four - has historically been an above average year where the Gradient 50 or Gradient Covered Call portfolio would provide excellent returns with a slight element of downside protection.

Remember, the Presidential Cycle theory is just that, a theory derived from a historical return pattern. Many other things are constantly affecting the stock market at all times in addition to the year of the Presidential term. It is wise to take them into account when making your investment decisions.

GRADIENT

GRADIENT INVESTMENTS, LLC - AN SEC REGISTERED INVESTMENT ADVISOR

I N V E S T M E N T S , L L C 4570 Churchill Street, Suite 200, Shoreview, MN 55126 |

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