Nick Dewhirst takes a fresh look at the most enduring investment strategy of them all - the US Presidential election cycle - and its impact on Wall Street
As this issue marks the sixth anniversary of Portfolio Strategies it seems appropriate to comment on the conclusion of the very first column I wrote.
It stated: "Should the new millennium herald a new era of investing, it may well be that markets cease to skyrocket but return to earth as gravity re-exerts itself. If so the fashionable buy-and-hold strategy would become old hat and investors will have to work for their profits again, exploiting cyclical swings in asset classes to maximise gains"
That could not have been more right. In the following two years, the S&P Composite index fell 29%. It is appropriate because my opinion was based on the most enduring investment strategy of all. It has a track record going back 175 years and it is the US election cycle.
It is also appropriate because it is now exactly a cycle-and-a-half later. Intermediate two years' reviews confirmed that this is still a useful investment strategy, even though it needs to be adapted to prevailing market conditions.
fall and rise
According to the old Wall Street adage, it pays to buy at the mid-term and sell at the full-term elections. The record collated by the Stock Trader's Almanac shows that up to 1980, on average the market fell 1% in the year after the Presidential election, rose 2% in the following year, 7% in the year after that and 5% more in the pre-election year.
Thereafter, the strategy needed to be adapted for the great bull market brought about by the defeat of inflation. The consequent once in a lifetime re-rating of shares raised the long-term growth rate from 3% to 12%. As inflation fell from 15% in 1980 to 2% by the millennium, rising P/E ratios alone accounted for five of the 15-fold rise in share prices.
For that period it was necessary to reformulate the adage, to Wall Street underperforming in the initial two years and outperforming in the latter two years of the cycle. Thus, the two relatively poor years of +12% and +8% were followed by two better years of +18% and +10% until the millennium.
Moving on to my next review of this strategy two years later, it was clear the bursting bubble had indeed brought to an end the secular bull market as suggested in the initial review, so the pattern should revert to "cyclical swings".
Therefore, I wrote at the end of 2002: "Now the cycle has turned half-circle, it should be time to become bullish if the pattern is to repeat itself."
That too proved correct - the stock market rose 25% in the following two-year run-up to the next Presidential election.
However, the next cyclical signal proved less successful. Rather than falling for two years after the election, the market rose by 19%.
Nevertheless, this was a period where Wall Street underperformed, because the rest of the world's stock markets rose 44% - more than twice as fast, driven by integration of emerging markets into the global economy.
the pork cycle
So what should one expect now? If Wall Street rose in the first two years, will it fall in the second two years of the election cycle? Not, if past experience is any guide.
That suggests Wall Street will rise even faster in the next two years. Can one really expect the index to rise for two more years, even though it is already standing at a six-year high and is only 10% below its all-time high?
The answer lies in understanding why the strategy works. To do that I renamed it the Pork Cycle, after the long tradition of pork-barrel politics in the US, and based on the premise that actions in one period have side-effects only in later periods, which in turn require the initial action to be reversed. For the purposes of stock market cycles, these are pre-election promises and post-election disappointments.
In the post-war era this had typically meant a pre-election consumer boom caused post-election inflation, which in turn could only be stopped with soaring interest rates, that in due course also deflated demand. However, such cyclical economic management has long been brought into disrepute and the Federal Reserve has re-established genuine independence.
Nevertheless, the basic prem-ise of pre-election promises and post-election disappointment remains intact. Beforehand both parties raise voters' expectations through their competition to 'buy' votes. Afterwards these promises may prove difficult to enact in a political system, whose dispersal of power is designed to frustrate extreme change. Alternatively they may prove unaffordable, unworkable or produce unintended consequences. Whichever way, political disappointment follows.
thermometer of expectations
That disappointment displays itself also in the performance of the stock market. This is also a thermometer of expectations, comparable to an election, but for finance rather than politics. At this point in the cycle the thermometer should be rising, irrespective of the level at which it starts.
This strategy also gives another clue to the direction of the stock market. That is the party in power at the White House. Over the past 40 cycles, the stock market has on average performed 5% better when the occupant is a Republican, so justifying the view that it is the party of business.
Given that the incumbent cannot be re-elected, having served his two terms, the odds are in favour of the next President being a Democrat, which would be a bad signal for the stock market, but only in two year's time, when the cycle is due to turn down after the next election.
Meanwhile, the Pork Cycle suggests the answer is yes, the stock market will continue rising for another two years.
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