God is a Capitalist

Tuesday, February 18, 2014

Presidential Returns

In honor of President's Day this week I decided to take a look at a popular cyclical candidate running to help you time the stock market - the presidential election cycle. Jeffrey Hirsch, chief market strategist at the Magnet Æ Fund and author of The Little Book of Stock Market Cycles wrote about the technique in "Using Seasonal and Cyclical Stock Market Patterns" in the June issue of AAII's Journal. Hirsch's Stock Trader's Almanac has followed this cycle for fifty years and found it profitable.

Here is his graph of the average returns for the Dow Jones Industrial Average in each year of the four-year cycle from 1833-2012:

 Figure 1. DJIA Average Annual Percentage Gain (1833–2012)

Hirsch explains that, "In an effort to gain reelection, presidents tend to take care of most of their more painful initiatives in the first half of their term and 'prime the pump' in the second half so the electorate is most prosperous when they enter the voting booths. The 'making of presidents' is accompanied by an unsubtle manipulation of the economy...By Election Day, he will have danced his way into the wallets and hearts of the electorate and, it is hoped, will have choreographed four more years in the White House for his party."

After the election, reality asserts control:

"Most bear  markets began in such years—1929, 1937, 1957, 1969, 1973, 1977 and 1981. Our major wars also began in years following elections—the Civil War (1861), World War I (1917), World War II (1941) and the Vietnam War (1965). Post-election 2001 combined with 2002 for the worst back-to-back years since 1973–74."

Hirsch also discusses the best six months for investing and the January indicator. I think all of the indicators are good, but the election indicator is probably right for the wrong reasons. Federal spending is just 20% of the economy and many estimates of the multiplier are small, so I doubt it affects the economy as much as Hirsch does. In addition, federal spending would affect profits, but growth in the PE ratio, which indicates greater risk tolerance by investors, accounts for about half the variation in stock prices.

The is enough slippage in the accuracy of the presidential cycle that an Austrian economist could reasonably thing that what he calls the election cycle is really the business cycle, which averages 4 to 5 years over the long run. Understanding the business cycle and how it affects the stock market is important for avoiding major downturns in the market.

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