Third Year Charm? When The Presidential Cycle Backfires

As the market powers ahead, many are turning to the Presidential cycle as an explanation. Even Jeremy Grantham, in his latest quarterly letter (Pavlov’s Bulls) begrudgingly acknowledged that with the help of this powerful seasonality, the stock market could continue until October 2010 and potentially reach as high as 1400-1500 (S&P 500 index).

And of course, we are all by now well familiar with this four year phenomena, also known as the election year cycle. First pointed out by Yale Hirsch in his seminal work, the Stock Trader’s Almanac, it has now become common knowledge. The data shows that the “sweet spot” for the election cycle is towards the latter part of the second year and the (full) third year – when the vast majority of the outperformance shows up.

But what if we were to look a bit more closely at this crucial third year? Let’s say, for a lark, that we look at the performance of the stock market depending on whether the sitting president is elected again or he becomes a one-term president.

This is exactly what Geroge Slezak of was thinking recently. For those unfamiliar with Slezak, he is a well established stock newsletter writer and he was recently ranked the third best market timer by Timer Digest. Clearly, Slezak is deserving of our attention.

You can look at the charts Slezak presents and listen to his audio presentation here. Slezak points out that there is a big difference depending on whether the sitting president is elected again or not.

In a slideshow presentation, he shows the presidential cycle for each instance. But I wish he had actually shown the annual and average performance of the Dow based on the criteria he proposes. Being curious, I went ahead and did the work to fill in this oversight.

I calculated the annual return for each 3rd year in the presidential election cycle. I then separated the returns based on whether the incumbent president is once again elected or if he is replaced (either by being voted out or by death). Here is a chart showing the annual returns with the orange representing the 1 term presidents and the blue the successfully reelected ones:

Before we get to the numbers, you’ll notice that the majority of the time, the incumbent wins again (67% of the time in fact). So we have just 10 data points for the instances when the sitting president is not elected (orange bars). I’ll leave it to the statisticians to fight amongst themselves about whether this is a large enough sample or not.

In any case, when the sitting president is elected again, the market does really well – on average rising 17.8%.

If he’s not elected again, the average annual return for the third year is just 1.11%.

That is a huge difference!

You’ve probably also noticed that there are two very large data points that could potentially skew the averages. In 1915 the Dow gained appx. 82% (as Wilson was re-elected) and in 1931 the Dow fell 55% as Hoover lost to Franklin Delano Roosevelt. Removing these two reduces the gap but it is still very large: 14.5% (for 3rd years in the presidential election cycle when the president was re-elected) compared to 7.38% for those years he wasn’t. That’s still a gap of almost double.

Knowing that there is a bifurcation in this seasonality tells us one important thing: the 3rd year is not guaranteed to be a boon to equity investors. Unfortunately, it doesn’t really help us out that much in predicting what will happen to the Dow Jones in 2011. That’s because whether the president is re-elected or not largely depends on how successful he was in managing the economy and keeping people happy.

Usually when presidents fail to bring prosperity, they are voted out. So the re-election of Obama depends largely on how well the economy and stock market does this year. If it turns out that the US economy falters back into recession, the presidential election cycle is in no way a guarantee of higher stock prices. In fact, the historical pattern suggests that the market would be relatively weak. Slezak suggests we closely monitor the next few months because they will set the tone for the rest of the year.

One caveat: I estimated the annual return by eyeballing the charts for the very early years of the Dow. If anyone has data for these early years of the Dow, drop me a line. I’d really appreciate using accurate daily data.

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One Response to Third Year Charm? When The Presidential Cycle Backfires

  1. Adrian Wu says:

    This phenomenon fits neatly into Robert Prechter’s socionomics theory. BOTH the stock market and the economy are under the control of social mood, which has an intrinsic periodicity. Of course, when the social mood is low, voters are more apt to throw out the incumbent leaders. The social mood is not a result of economic conditions; witness the change in mood in mid to late 2007 (coinciding with the all time peak in the stock market) and the roaring economy still in effect at the time. The economy then tanked AFTER the social mood and the stock market fell.

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