A Look at the Third Year of the Presidential Cycle, and the Stock Market

A Look at the Third Year of the Presidential Cycle, and the Stock Market

Next Year – The Third Year of the Presidential Cycle!

Being Street Smart

Sy HardingSy Harding

December 20, 2010.

The history of the Four-Year Presidential Cycle is that the stock market tends to experience its worst corrections and bear markets in one or both of the first two years of a president’s term, and then be positive for the last two years of the term.

In fact, studies have shown that if investors were to stay out of the market for the first two years of each presidential term, and then buy and hold for the last two years they would substantially outperform the market over the long-term.

So, obviously the presidential cycle has a big influence on the stock market. Administrations of both parties tend to allow corrections of excesses to take place in the first two years of their terms, and then pull out all the stops with economic stimulus to make sure the economy and stock market are recovered and looking good when re-election time rolls around. That in turn usually results in the economy being overheated, and the stock market being over-valued again, and the cycle repeats, with the next administration then allowing those excesses to be corrected in the first two years of its term.

However, as the last four years have shown, there are sometimes exceptions in the shorter term. The 2007-2009 bear market began in the third year of the Bush administration and continued down through the fourth year, and the market has been up quite strongly for the first two years of the Obama administration.

The obvious question is whether the cycle has reversed this time. If the market was up for the first two years of the term will it be down over the last two years of this cycle?

The answer is that it’s not likely.

I studied the market going back to 1915. There were seven other instances when the market was up for both the first and second year of the cycle. It did not affect the history of the last two years of the cycle usually being positive. Only once was the market then down for the third year. That was in 1923, and the Dow was down only 3.2% for the year.

However, I also went back to 1900 to check out the market’s performance in the third year of the cycle regardless of what it did in the first two years, and found that third years of presidential terms were not impressive prior to World War II.

I count five times out of the first ten presidential cycles from 1903 to 1939, or 50% of the time, that the market was down in the third year of a president’s term. Two of the declines, in 1903 and 1907 were actually bear markets, with the market being down 22.4% and 37.7% respectively in those years. It was also down 53% in 1931, the third year of Herbert Hoover’s administration (during the severe 1929-32 bear market).

But all of those negative third years were prior to World War II, not in the post-1950 modern market era.

It can be misleading to only look at the market’s year-end levels to determine risk, as doing so does not take into account the corrections that can take place within a year.

For instance in 1987, the third year of President Reagan’s second term, the market was up 2.3% for the full year. Easy enough to buy and hold through?

Definitely not. The Dow reached a new record high in August of 1987. But it then topped out into a serious bear market that culminated in the October 1987 crash. In that three-month decline the Dow lost 36% of its value, and panic prevailed. Even Wall Street conceded that the market was probably headed lower, and that the similarity to the 1929 crash might result in the economy falling off a cliff into another Great Depression. There were probably few buy and hold investors left by the time the market instead recovered to close up 2.3% for the year.

So I also checked out the intra-year corrections within other years, and nothing like 1987 occurred in the third year of other administrations. With the exception of 1987, between 1943 and 2007 the short-term corrections within a third year averaged only 8.5%, with the worst being 16.1% (in 1971).

So, although it’s not quite the sure thing Wall Street is assuring us of, it is true that at least since 1940 the third year of the presidential cycle has always been a positive year with only relatively small ‘drawdowns’ in corrections during the year, with the exception of 1987.

That does not mean they are necessarily wildly positive. Some of the third years, while positive, were only marginally so, for instance 6.1% in 1971, 4.2% in 1979, 2.3% in 1987, 6.4% in 2007.

However, based solely on the Four Year Presidential Cycle it does look like 2011 should be a low-risk year, even though the first two years of the cycle were already quite positive.

Of course there is always the possibility other factors, maybe even the current high level of investor bullishness that may have already factored a positive 2011 into stock prices, will become a larger factor than the Presidential Cycle this time around, as happened in 1987. But whoever said that investing was easy? However, it’s usually easier when the odds presented by the Four-Year Presidential Cycle are in your favor.

Sy Harding is editor of the Street Smart Report, and the free market blog,www.streetsmartpost.com.