Presidential Cycle Impact on the Stock Market 2010

By: Sy_Harding

In last week’s column I discussed academic studies that confirm the remarkable consistency of the market’s annual seasonal pattern, how with few exceptions markets in the majority of countries tend to make most of their gains in the winter months, and experience most of their serious corrections and bear market declines between May and November.

I cautioned that because 2009 was one of the rare years when those seasonal patterns did not appear, investors should not be lulled into a false sense of security, that they may be surprised how aggressively the seasonal pattern bounces back in 2010.

There is another historical pattern that also has to be considered for next year. I remind you of it every four years. It’s the Four-Year Presidential Cycle.

The history of the Presidential Cycle is that the economy and stock market tend to have problems in the first two years of each new president’s term, and then recover and be robust over the last two years of the term.

Studies show the reason for that pattern is that each new Administration realizes the economy and stock market must be strong when the next election time rolls around if they are to be re-elected. So they pull out all the stops to stimulate the economy to make sure that happens. However, all that excessive priming of the pump usually has the economy overheated, and the stock market overbought and overpriced, by the time the next election takes place.

Those excesses then need to be corrected, the corrections taking place in the first two years of the next term. Then stimulus efforts begin again to make sure the economy and stock market are strong again for the following election.
The cycle has a very consistent pattern. For instance, almost all bear markets have taken place in the first two years of the presidential cycle, and almost all recoveries have been underway in the last two years of the cycle.

The pattern is not consistent when a president is in his second term, perhaps because he cannot be re-elected. For instance, the pattern was clearly evident in Reagan’s, Clinton’s, and Bush Jr’s first terms. But normal corrections were not allowed to take place in the first two years of their second terms, the economy and market just kept on going. That allowed the excesses to become more serious. So the 1987 crash took place in the third year of Reagan’s second term, the 2000-2002 bear market began in the fourth year of Clinton’s second term, and the recent 2007-2009 bear market began in the fourth year of Bush’s second term.

However, although the problems started a year earlier for the next president in those instances, in the final year of the previous administration, the corrections (a crash and two severe bear markets) were so severe that it still took until the 3rd year of the next president’s term to see recovery clearly underway.

So what does that mean for next year, when we have a president in his first term, and next year will be the second year in this presidential cycle?

There will still be economic problems, in the real estate sector when the program of big tax rebates to home buyers expires in the spring, in the financial sector as commercial loan defaults continue to spike, in consumer spending (75% of the economy) as consumers remain hunkered down under high debt levels and high unemployment. No one expects any more than tepid economic growth next year. There may even be a dip back into recession for a quarter or two. Of the seven recessions since 1957, five had W bottoms rather than V bottoms. That is, they experienced one or two positive quarters and then dropped back into recession for one or two quarters.

So between annual seasonality patterns probably returning, and economic problems not having gone completely away, and next year being the 2nd year of the presidential cycle, we can expect problems sometime during the year for the stock market.

However, there is something else - a big positive.

The most consistent market pattern we have ever encountered is that since at least 1918 there has been a substantial rally from the low in the second year of every Presidential term to the high the following year. That is so whether it was a president’s first or second term. Even the conservative Dow gained an average of 50% in those rallies.

It has taken place no matter which political party was in office, in periods of war or peace, high or low interest rates, high or low inflation, high or low budget deficits, or whatever.

In fact the market makes most of its long-term gains in the period from the low in the second year of the presidential cycle through the following election year. It’s a period when you would not want to be out of the market, a period when even buy and hold investing is at its best.

The problem is in getting safely to that low. Historically, it has more often taken place in the fall, but over the years every month has had a turn or two in producing the low, even January.

So, it is highly likely there will be an important time next year to take profits and stand aside, to avoid the large losses that have taken place within each year recently. But also a time to buy with both hands, to even use margin and leverage. But it will be tricky to identify those key turning points. The problem is not made easier by the fact that each of the last two years experienced serious downturns right out of the gate, beginning just a few days into January.

For that reason, although our Seasonal Timing Strategy is in its favorable season and subscribers are 100% invested, we have a very close protective stop on its holdings to prevent a loss of any size, while our Market-Timing Strategy portfolio is still on a buy signal, but now only cautiously invested in diversified holdings at least until we have the data for the first few days of the new year.

Sy Harding is president of Asset Management Research Corp, publishers of the financial website www.StreetSmartReport.com, and the free daily market blog, www.SyHardingblog.com.

Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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