The Presidential Cycle: 3rd Year Performance

The presidential cycle exerted a powerful influence over the trading pattern of 2010. The second year of the election or presidential cycle is relatively weak until we get to the last 3 months of the year.

The first quarter of the year was positive with the S&P 500 index returning 4.7%. The second quarter was, in keeping with this cycle, negative with a loss of 12%. The third quarter was outside the pattern with a positive return of 11%. And the final quarter provided another +10%.

The real story of this pattern however transcends the fiscal calendar year. The strength of the presidential year cycle extends from the last quarter of the second year into the first and second quarter of the third year. In other words, in our current case, from October 2010 to July 2011.

You can see this in the chart below which compares the average year performance for equities from 1900 to the present to the third year of the presidential cycle:

Source: Chart of the Day

For all the bullish sentiment and the signs of extreme enthusiasm out there, the market does have the wind at its back. At least for several more months. In fact, since 1930, the last time there was a down year in this cycle was 1939 when the S&P 500 index lost 5.45%. Taking the short term view, the month of January in the third year of this pattern has also been very strong. The S&P 500 has historically shown a median weekly return of +0.77% in January, compared to +0.28% at any other time. For more historical data see this post by Frank Hogelucht at Trading the Odds.

Another seasonality is the four year cycle which last presented us with a ‘buying opportunity’ in 2010. This is a much simpler cycle which shows a high probability of a significant low (buy opportunity) every four years in the stock market. There have been exceptions of course, but they are very few. If 2010 is the rule rather than the exception, this means that the buying opportunity that presented itself was in July 2010. So far the S&P 500 has climbed 23%. And historical seasonality from the election cycle suggests that it will continue.

All major indicators such as breadth and technicals that we’ve looked at are saying that the cyclical bull market that started in March 2009 is not yet ready to end. I’m expecting some major turbulence in the new year because there is way too much complacency at the moment. The seasonality studies are obviously known to traders and some of the enthusiasm can be attributed to such assumptions. My thesis is that the market will need to shake off the weak hands before it can continue higher.

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