The Presidential Cycle 2016 and 2017

Once upon a time, the 4-year Presidential Cycle was reasonably predictable. In the year of the election, the incumbents would try to boost the economy, which was reflected in the stock market, and everyone would be happy. In the year after the election the President was able to implement a few of the more visible campaign promises and the market continued to rally. But life changes and clearly, so does politics – or so we think from the past few years.

If we look at the big picture (Chart 1), using the cash S&P Index from 1948, we see that the 3^rd year of office (2015, 2019) had the best returns, while the other years were very similar on average. If we separate 1948-1999 from 2000-April 2016, we see that it’s the recent period that has changed dramatically. We won’t try to explain what has happened, because hindsight always makes us look smart, but rarely helps us forecast the future. Instead, we’ll let the numbers speak for themselves. We need to decide if this is a structural change or just a temporary anomaly.

Chart 1. The big picture (blue shows all years) has the 3^rd year of the Presidency as the best, but is very different from the recent period, in gray.

We know that each cycle could vary considerably from the average, in particular the 1980 gold peak, the 1987 crash, and the 2000 internet bubble, so the average hides a lot of volatility. We can see this volatility in Chart 2. Although the election year and the two years that follow showed stable average returns (seen in Chart 1), the election year had a 39% loss in 2010. Other years have been much more stable, with the third year the most consistent. We’ll need to wait for 2019 to take advantage of that.

Can we really predict the volatility? Not likely. A financial crisis doesn’t have to come in any particular year, so 2017 may post a large loss. On the other hand, politicians may try to keep the economy on track as we near an election or, at least, try to hide any shortcomings. So the remainder of 2016 could even be stable, if not completely uneventful.

Chart 2. Volatility range, separated by Presidential Cycle, from 1948. Only the 3^rd year of the cycle has low volatility.

A Closer Look Tells Us More

If we remember that the years after the financial crisis (2008) saw a remarkable bull market, it should not be surprising that the last two cycles show profits. So let’s take a closer look at the yearly returns.

Chart 3. Detail of the election year cycle. Each chart shows the history of one year in the cycle.

Data source: CSI

Chart 3 shows each cycle from 1948. Remembering that there is an upwards bias in the stock market, we should expect each year of the four cycle years to be positive, on average. The election year may be distorted by 2008, but seems to be less positive and more sideways during the past four cycles. The first year in office (2017) has been generally good since 1985, and 2013 was no exception. The second year, when they elect a new congress, is anyone’s guess.

Then we have the third year. Historically, this has been the most consistently successful year for stocks, but the last two cycles have suffered from a congressional stalemate. We can hope this resolves itself by the time this cycle comes around again, in 2019.

Trading the Cycle

If we look at the accumulated profits from trading each cycle year (Chart 4) there is the overall upwards bias, but only the election year (2016) seems to be failing after a long run of success.

Chart 4. Returns trading each cycle year.

What can we expect going forward? Do times really change? Consider what two well-known market philosophers have said:

“Suppose you were an idiot. And suppose you were a member of Congress. But I repeat myself.” – Mark Twain

“Politics is the art of looking for trouble, finding it everywhere, diagnosing it incorrectly, and applying the wrong remedies.” —Groucho Marx

And more recently,

“Our intent will not be to create gridlock. Oh, except maybe from time to time.” —Bob Dole

If we look to the past for answers, as I choose to do, the current political situation is not unique, and I would expect the long-term patterns to continue. Of course there will be price shocks from time to time that disrupt the market. The shock in 2008 was larger than usual, but not any worse than 1929 or 1987. While upsetting to most investors, it is also normal. Over time, both positive and negative runs become longer, and at inflated prices, shocks will be larger.

To come back to the original question, do we expect the old patterns to persist or are we in a new regime where nothing happens? As a game player, the best solution is to be able to take advantage of one scenario without eliminating the other opportunity. Looking first at the election year pattern, the exceptional large loss was in 2008 and that seems unlikely to have had anything to do with the Presidential Cycle. That aside, the risks of being long are modest and so are the returns.

It looks much more promising for 2017. The individual years, shown in Chart 3 as “1^st year in office” show very good returns. If we’re wrong, and there is continued stalemate in Congress, those gains would disappear but losses do not necessarily follow. The expectation is simply unknown. Being more aggressive in 2017 could pay off.

Times don’t always change, and we should not confuse normal variability with structural change. Much like a commodity cycle, which can be temporarily disrupted by bad weather, I expect to say that this political cycle reflected only short-term indigestion.