The Presidential Election Cycle Theory: Is It Accurate?

The presidential election cycle theory was developed by market historian Yale Hirsh. The key assumptions for this theory are that:

• Markets do well in a presidential election year.
• Markets do even better in the year leading up to the election.
• Markets are best performing in years three and four of the current term.
• Markets are worst performing in years one and two of the new term.

Although contended by many economists and financial theorists, this theory has been surprisingly accurate. The following is a look at the annual S&P 500 returns (adjusted for dividends).

A look at the actual numbers shows that that there is indeed a relatively strong and repeating pattern:

How does this trend occur if we believe that, the primary drivers of market returns are the underlying economic and stock market fundamentals? Why and how do political movements through fiscal, regulatory and monetary stimuli influence the economy and subsequently stock market returns in such a recurring pattern?

Perhaps the answer lies in the individual self-interest of politicians. Individuals are motivated to take political action to retain office for themselves or for their parties. During the first and second terms in office, presidents tend to focus their campaign platform promises and sanction tough legislations related to tax increases, regulatory changes, government budget cuts and social policy decisions like universal healthcare coverage or tuition cuts.

In the third and fourth years in office as presidents look forward to the election, they tend to use fiscal stimulus such as tax cuts or government budget increases to pump up the economy and build voter confidence for the incumbent party.

In addition, the Federal Reserve has also played an active role in this economic/political cycle. A study by Robert Johnson and Scott Beyer in the Journal of Portfolio Management (2007) found that the Fed policy is more accommodative in the second half of the presidential term, particularly in year three; note that this is the year when the market is gaining the most.

The 2008 Election and Beyond

The intent of this article is not to forecast the market. Even though patterns exist, there is enough variability that it is risky to try and anticipate where the market is headed. As can be seen with the current situation, this theory is not foolproof as 2008 is unlike most election years. Although still not acknowledged by optimists, the fact is that we’re in the mist of a recession as the financial industry struggles, consumer spending is down, corporate profits are shrinking, inflation is looming at large and unemployment inches higher every day. The S&P 500 is already down by about 7% from the beginning of the year.

The current administration has approved a $168 billion stimulus package in hopes of breaking out of this recession. Although I hope we can accomplish this soon, my bearish outlook on the economy remains for many reasons – one of them being that the presidential election theory illustrates a gloomy outlook for 2009.

Disclosure: None.