The third year of a president’s term in office has historically been especially good for the stock market. That’s especially welcome news given recent market weakness and Wednesday’s big selloff.
The third fiscal year of President Obama’s second term began yesterday, according to many researchers who have studied the presidential election year cycles. They tend to focus on fiscal years beginning with the fourth quarter.
Skeptics say we can’t count on history repeating this time around, arguing that the Federal Reserve’s extraordinary monetary stimulus has likely thrown many of the markets’ normal cycles out of whack. They believe that the Fed’s actions have had the effect of transferring into past years the strength that the stock market would otherwise have been expected to experience in this upcoming third year.
Consistent with their argument is the stock market’s impressive performance over the last two years. Normally, according to the Presidential Election Year Cycle, those years should have been mediocre at best for the stock market. Unfortunately, no amount of historical analysis will allow us to test their hypothesis, since the Fed has never before engaged in a monetary stimulus program that is comparable in size to theirs of recent years. But, to the extent an analysis of the historical record does provide insight, it downplays the skeptics’ worry. Third years are just as good for the market following strong years as they are following weak ones.
To be sure, that history doesn’t guarantee that the market will rise this year. The presidential election year cycle is not the only force influencing the market.
The theory behind the presidential cycle is that politicians will go to great lengths to get re-elected, including managing the economy. The implication is that, immediately after assuming office, presidents swallow whatever economic medicine is necessary — in order to set the stage for economic good times in the second half of their terms.
The historical data is largely consistent with this theory, especially as it applies to third years. Since the Dow Jones Industrial Average was created in 1896, the stock market during such years has gained an average of 15%, rising 82% of the time. That’s nearly four times the average gain in all other years of 4.4%. During those other years, furthermore, the market has risen 58% of the time.
The contrast is even starker if we focus on the period since 1940. Some believe that’s the most relevant point at which to begin measuring the impact of the Cycle, since the Federal government’s role in the economy — and, therefore, the White House’s ability to influence electoral outcomes — grew markedly during the New Deal and World War II. Since 1940 the Dow has risen in 100% of third years, gaining an average of 22.3%. That contrasts with an average gain of just 3.1% during all non-third years since 1940. In years one, two, and four, the market has risen 57% of the time.
The historical data contain no evidence that the market’s expected third-year return is lower following a strong second year. If anything, it’s just the opposite. As the accompanying table shows, the market since 1896 has actually performed better during those third years that followed second-year gains than those that followed second-year losses.
What about third years of a president’s second term, as is the case today? It certainly seems plausible that the Presidential Election Year Cycle would be weaker during second terms, since re-election is not an option. But there is no historical support for this suspicion, since — as the table shows — the market in the past has been slightly stronger during third years of second terms than in first terms.
Finally, what if we slice and dice the data even more finely, focusing on just those third years of second terms that followed strong second years? The sample size shrinks to a very small number when we do that — just six over the past century, in fact — so it is almost impossible for the results to be statistically significant. But notice from the table that, in any case, this more narrow focus does not lead to any big difference in expected third-year performance.
The bottom line?
The strong stock market of the last 12 months notwithstanding, the Presidential Election Year Cycle is still forecasting a good market over the coming year.
Authored by Mark Hulbert via barrons.com.