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BEING STREET SMART

by Sy Harding

The Very Important Four-Year Presidential Cycle. 2010.

While most investors have at least heard of the Four-Year Presidential Cycle, few are aware of its particulars, or of its unusually consistent impact on the economy, the stock market, and the country’s general well-being.

The cycle begins every four years at the end of each election year. Basically it is this:

History shows a very strong tendency for the economy and stock market to experience difficulties in the first two years of each new Presidential Administration, and then to experience recovery and strong growth in the last two years of each term.

The driving force is the desire for each new Administration to be re-elected when the next election rolls around in four years, and both political parties learned long ago that the most important factor for voters at election time is the condition of the economy. Regardless of how positive other factors may be at the time, almost no incumbent party has ever been re-elected if the economy is struggling when voters go to the polls.

Therefore, it has been common since at least 1918 for the incumbent administration to do whatever it takes in the last two years of each Presidential term to make sure a prosperous economy and stock market are in place when the next election arrives. Such pump-priming traditionally includes increased government-spending, cuts in interest rates and taxes, even tax rebates. The intent is to encourage consumers to spend more (consumer spending accounts for approximately 65% of the economy), which will result in businesses having to buy more equipment and hire more workers.

It doesn’t always work to get the incumbent party re-elected, but works just about every time to create a strong economy and stock market by the time the next election time rolls around.

However, the extra stimulus efforts in the last two years of each term also almost always results in the economy and stock market being pumped up too much. Excesses are created that need to be corrected after the election. Those excess usually include some form of an overheated economy that is threatening to produce inflation, excess government, consumer, or corporate debt, and an overbought and overvalued stock market, sometimes even a ‘bubble’ in one or two investment areas.

So after each presidential election the newly elected (or re-elected) administration tends to allow the correction of those excesses to take place in the first two years of the next four-year cycle. In fact, if market forces are not producing the corrections, Washington often forces the issue by raising interest rates to cool off the economy, while backing off on government spending and job creation.

It makes sense that they would want the economy and stock market to undergo any needed correction of excesses in the first two years of the new term. If they tried to keep the economy and stock market pumped up for another four years, all the way to the next election, they would run the risk of even greater excesses developing, which in turn might result in a large correction, or even a market crash late in the term just as the time of the next election arrives.

We have seen several examples of the latter, when administrations did not allow corrections in the first two years of a term, and instead tried to keep the economy and stock market booming through their entire four-year term.

For instance, the Reagan Administration in its second term in the 1980s, the Clinton Administration in its second term in the 1990s, and the George Bush Jr. Administration in its second term in the 2000s.

All three followed the historical norm in their first terms in office, allowing and even engineering an economic slowdown and market correction in the first two years of the terms, and then pulling out all the stops to re-stimulate the economy and stock market in the last two years of their first term, in time for the next election.

But after being re-elected, they did not allow a slowdown in the first two years of their second terms, all three keeping the economy and stock market pumped up through the first two years of their second terms, taking a chance that they could keep them strong all the way through their second terms.

The result for the Reagan Administration was the 1987 crash, in the 3^rd year of its second term. The result for the Clinton Administration was that the stock market wound up in a bubble in 1999, the third year of its second term, and that bubble burst into the severe 2000-2002 bear market that began in the fourth year of Clinton’s second term. And for the George Bush Jr. Administration the result was that the recent severe ‘Great Recession’ and 2007-2009 bear market began in 2007 and lasted through 2008, encompassing the third and fourth year of Bush’s second term.

Those exceptions stand out starkly from the normal pattern of the Four-Year Presidential Cycle, and support the reasoning behind the consistent pattern. When an Administration is in its first term it has great incentive to follow the pattern, allowing a slowdown in the first two years of the term and then stimulating a recovery in the third and fourth year in time for their re-election. But apparently when an administration is in its second term, and cannot be re-elected, it does not have the same incentive to continue the pattern, and is tempted to try to keep the boom times going all the way through their second term.

Jeremy Grantham, founder and chairman of Boston-based Gratham, Mayo, Van Otterloo & Co., highly respected international managers of $140 billion in client assets, says of the Four-Year Presidential Cycle:

“All markets tend to drop in the first two years of a presidential cycle. The key for people to remember is that whoever is president has astonishingly little effect, whereas the cycle itself, the desire for the incumbent party to get re-elected is clear in the data. . . . . . The precipitating factor is economic house-keeping by officials in Washington. Presidential Administrations want to correct imbalances in the economy and smarten-up balance sheets in the first two years of their term, so they will have breathing room in year-three to stimulate the economy and set things up for the next election. . . . . . . An unintended consequence is that the stock market usually falls in the first two years of the cycle.”

The first term of the Bush Jr. Administration is the most recent example.

The severe bear market that began in 2000, the 4^th year of Clinton’s second term, continued in 2001 and 2002, the first two years of the new president’s term. The Bush Administration, following the normal pattern of the cycle, did little about it beyond the typical ‘jaw-boning’ and rhetoric, assuring the country that “The U.S. economy is vibrant and will recover.” Washington occupied itself with mending political fences after the embattled Bush/Gore election, and planned for its goal of spreading democracy around the world. The terrorist attacks of September 11, 2001 came along, and further occupied the Administration with the launching of the war on terror, the invasion of Afghanistan, and development of Homeland Security.

However, in the following year, the second year of the first Bush term, just as the Four-Year Presidential Cycle would have us expect, and even as the Administration could have been even more distracted by preparation for the invasion of Iraq, Washington moved the economy to center stage. It launched the most aggressive economic stimulus effort the nation had ever seen (although it was to be dwarfed by the stimulus efforts six years later in 2008 and 2009). The Bush Administration increased government spending exponentially, to expand the military and fund growing homeland security efforts, at the same time providing tax cuts and even tax rebates, and with a series of dramatic interest rate cuts that soon had mortgage and other loan rates at their lowest levels in 45 years.

Sure enough the economy responded, and from its bear market low in October, 2002, the second year of President Bush’s first term, the stock market launched into its next bull market, that of 2003-2007. Once again the stock market’s Four-Year Presidential Cycle, extremely consistent in a president’s first term, of weakness in the first two years and strength in the second two years, had taken place.

In my most recent book, Beating the Market the Easy Way, published in 2007, I noted that as had been the case with Reagan’s and Clinton’s second terms, there had been no slowdown in the economy and no bear market in stocks in the first two years of President Bush’s second term.

And at the time of writing the book, the real estate bubble had burst, suggesting that would bring the troubles in the third or fourth year of the Bush second term, as had happened with the Reagan and Clinton second terms.

And that is what happened, with the recent Great Recession and most severe bear market since the 1930’s taking place from late 2007, through 2008 (and into the March low in 2009, two months after the next Administration took office).

Two tables of importance in understanding the consistency of the cycle.

TABLE 1:  All the bear markets since 1917.

Note that 15 of the 20 bear markets ended in either the 1^st or 2^nd year of a president’s term, (those in green), regardless of which party was in office. Four of the five exceptions (in black) were when it was a president’s 2^nd term.

So the only term since 1917 in which a bear market was underway when a president was in office in his first term, and the bear market did not end in either his first or second year in office was Hoover’s. However, the 1929 crash took place in his first year in office, continued through his second year, and then third year, not ending until 1932. So the first half of the Four-Year Presidential Cycle pattern, weakness in the 1^st or 2^nd year of the cycle, certainly took place.

The next table illustrates the other important very consistent pattern of the Four-Year Presidential Cycle.

It is that since at least 1918 the market has experienced a big rally from the low in the 2^nd year of every Administration to the high the following year. The average market gain in that rally has been 50.1%.

The table goes back to 1934, from which the rallies averaged 49.3%. (Results even more pronounced going back to 1918). 

TABLE 2: Rally from the low 2^nd year of every Administration to the high the next year:

It’s important to realize that those rallies took place in every Four-Year Cycle, no matter which party was in power, in times of war or peace, booming economic times or bad times, rising interest rates or falling interest rates, rising inflation of declining inflation. The pump-priming beginning in the second year of each presidential term, aimed at making sure the economy is strong by the next election, always produced a strong stock market rally from the low in the 2^nd year of the four-year cycle to the high the following year.

The dramatic variations in surrounding conditions during the last 75 years included eight terms when Republicans were in power, and ten terms when the Democrats were in power. They included times of relative trust and admiration for the President, and periods of terrible scandals, one resulting in resignation (Nixon), another in impeachment proceedings (Clinton).

They included the assassination of President Kennedy, and the assassination attempt on President Reagan.

Militarily they included long periods of relative peace, but also major wars, some popularly supported some not, including World War II, the Korean War, Vietnam War, the Desert Storm War, terrorist attacks on the U.S., and invasions of Afghanistan and Iraq.

They included periods of cheap energy costs with oil at $2 a barrel, and high energy costs with oil at $70 a barrel.

There was the rise of Japan as a world power in the 1980s, and China in the 2000s.

There were periods of huge federal budget deficits and times of huge budget surpluses.

There were periods of relative trust in corporations and financial institutions, and times of scandals and total distrust.

Yet through all those different conditions two situations remained constant. If there were any serious problems for the economy or stock market, especially when a new president was serving his first term, the problems almost always took place in the first two years of the term. AND since at least 1917, from the low in the 2^nd year of every president’s term the market experienced a rally to the high the following year, in which the market gained an average of 50%.

Lastly, the Four-Year Presidential Cycle is the market’s main long-term driving force.

 Just as annually the market makes most of its gains in the months between November and April, and suffers most of its losses between May and October, so over the long-term it also suffers most of its major declines in the first two years of the Four-Year Presidential Cycle, and makes most of its gains in the last two years.

Obviously, the time to be extremely cautious, and consider downside positions  is in the first two years of every Presidential term, and the time to buy aggressively is from the low in the 2^nd year of each term to the next election.

Sy Harding publishes the financial website Street Smart Report Online, and a free morning blog at www.SyHardingblog.com. In 1999 he authored Riding The Bear – How To Prosper In the Coming Bear Market, which correctly predicted the worst bear market since the 1930's was right around the corner. The 2000-2002 bear market, in which the S&P 500 lost 50% of its value and the Nasdaq lost 78% of its value, began just a few months later.  His latest book is Beat the Market the Easy Way - Surprising Seasonal Strategies that Double the Market's Performance.

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