The Four-Year U.S. Presidential Cycle and the Stock Market

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The Four-Year U.S. Presidential Cycle and the Stock Market

This article revisits the 2004 article, “Presidential Elections and Stock Market Cycles,” written by Marshall Nickles. That article found that all of the major stock market declines occurred during the first or second years of the four-year U.S. presidential cycle. No major declines occurred during the third or fourth years. More specifically, from 1950 to 2004 (using the Standard and Poor’s 500 Index), the most favorable period (MFP) for investing was from October 1 of the second year of a presidential term to December 31 of the fourth year. The remaining period—from January 1 of the first year of the presidential term to September 30 of the second year—was the least favorable period (LFP) for stock market investors. It appeared that politicians were anxious to exercise policies that were designed to pump up the economy just prior to a presidential election, which in turn had a positive affect on stock prices.[1]

Since 2004, the stock market environment has changed in ways that make it more important than ever to understand the relationship between politics and stock market behavior. Unlike the 2004 article that did not address the above in detail, this article will attempt to do so. More directly, we will focus on two broad issues. First, we provide evidence of the relationship between economics, politics, and the four-year presidential cycle; and second, we include an analysis of stock market performance during the 2008 period. In addition, we introduce a risk measurement for the stock market and argue that the 2008 stock market crash should be considered an anomaly. Finally, we conclude that the four year presidential stock market cycle is likely still in tack.

This article does not attempt to support or refute the Efficient Market Hypothesis, which states that it is not possible to “beat the market.” The academic supporters of this hypothesis believe that stocks always trade at a fair market value; therefore, it is unlikely to outperform the general market unless one assumes more risk. Rather, this article provides evidence that risk may be reduced and returns may increase when an investor considers how economic policy influences stock market prices during the presidential election cycle.

Relationship Between Politics and Economics

The 20th amendment to the U.S. constitution requires a presidential election to take place every four years, which turns out to be all years that are divisible by four (e.g. 2004, 2008, and 2012). The president assumes office the following January after the election. Once presidents take office, they realize that to get reelected they must try to make the economy as healthy as possible four years later. It is this consistency in the U.S. political process that also sets into motion fiscal policies that are frequently predictable and that often have a direct effect on the stock market. In the discipline of economics, fiscal policy is defined as an increase or decrease of taxes and or government spending. The direction that fiscal policy takes can often be directly related to the state of the economy at the time a new president is elected.

It is not surprising to see incumbent presidents push for votes by proposing tax reductions and or increasing spending on specific government programs as an election draws near. In addition, an incumbent political party may also try to persuade the Federal Reserve to complement the administration’s efforts through monetary policy, by increasing the money supply and reducing interest rates. Such fiscal and monetary policies may be introduced as early as the end of the second year of the presidential four-year term. If the results are favorable and the economy responds positively, corporate profits usually rise, and with them, stock prices—just in time for the next presidential election.

These policies can also lead to inflation, which can be disconcerting to investors. If this were to happen, a newly elected president could be pressured to reverse the fiscal and monetary stimulus policies of his or her predecessor, attempt to get inflation under control, and then hope to return to stimulus policies by midterm in preparation for the next election.

On the surface, the concept of inflation appears to be straightforward. That is to say, inflation is understood to mean rising prices. However, the real questions an investor should ask are what caused it, why can it ultimately be a negative for the stock market, and what can be done to reduce it. First, if inflation is the result of excessive fiscal and/or monetary stimulus—known as demand-pull inflation—simply reversing the stimulus policies can help to lower inflation. If, however, rising prices are caused by external factors like rapidly increasing global oil prices—known as cost-push inflation—it can be much harder to control. Since the mid-1980s, the U.S. economy has not seen much cost-push inflation.

When the Federal Reserve increases or decreases interest rates, it is often to combat inflation, to position the U.S. dollar for favorable international trade, or to address a weakening economy. The consequences of rising interest rates are increased costs for businesses and consumers, which in turn can slow aggregate spending and corporate profits, and ultimately depress stock prices.

The above sequence of events appears to be logical and may be taken for granted by many investors, but what they may fail to understand is that the sequence does not always work in lock step. In other words, the effects of rising interest rates often lag in its efficacy and may not have an immediate negative influence on the economy. This lagged relationship between rising interest rates, falling corporate profits, and ultimately declining stock prices can confuse unaware investors. This is because corporate profits can, for a period, continue to increase faster than the negative effects of rising rates. Simply put, over time rising interest rates can put downside pressure on stock prices. However, in the early stages it may not be entirely obvious what is happening to all but the most sophisticated investors, who can bid down stock prices in concert with the anticipation of falling corporate profits.

The inverse is also true: any effort to curb recessions with lower interest rates can have a lagged effect depending on the state of the economy and the magnitude of the decrease in interest rates. The lag effects on the economy can be as late as 6 to 18 months later, although it is often sooner for the stock market.[2]

Risk and the Presidential Cycle

If indeed policy makers are successful in exerting positive influences on the economy as elections approach, it should be logical to expect less volatility in the stock market. This led us to measure the relative changing levels of volatility (i.e. risk) between the first and second halves of presidential cycles. In addition, risk becomes greater the longer an investor is committed to the stock market. Therefore risk reduction may also be accomplished if one were invested for only approximately the second half of the U.S. four-year presidential cycle or about 50 percent of the time.

To verify our claim, we measured risk within presidential cycles since the 1950s. For the purpose of this study, risk is defined as market exposure to time and volatility. The Ulcer Index (UI), which was developed by Peter Martin and Byron McCann, measures such risk.[3] The UI measures the depth and duration of Draw-Downs (DD) from recent stock market peaks.[4] A Drawn-Down measures the peak-to-trough decline during a specific period for the stock market and is usually quoted as a percentage between the peak and the trough.[5] The lower the UI value the lower is the risk.

Figure 1 compares the average Ulcer Index for the first and second years of presidential cycles to that of the third and fourth years since 1950. The Ulcer Index in most presidential periods was higher in the first and second years, with just a couple of significant exceptions (1985 to 1988 and the most notable 2005 to 2008). In general however, the investment risk was higher in the first two years of the presidential cycle, consistent with underperformance of the stock market during that period.

Figure 1. Historical Ulcer Index Average during Presidential Periods

Historical Ulcer Index Average during Presidential Periods

Note: This figure shows the average Ulcer Index for the first two years of each presidential period, compared to the average for the third and fourth years.


Favorable and Unfavorable Periods

With the above in mind, one should see higher performance for the stock market in the form of favorable and unfavorable periods within stock market cycles. To analyze the historical performance of stock price behavior, we opted to use the Dow Jones Industrial Average (DJIA) instead of the commonly used Standard & Poor’s 500 Index (with a ticker symbol of SPX). The specific reasons for selecting the DJIA were as follows: First, it is recognized as a leading measure of the general market, is well published and quoted, and has been around the longest among all the general stock market measures. Second, the DJIA appears to be less risky than other popular stock market indexes like the SPX. During the period 1950 through 2011, the UI for the DJIA was 13.5 while it was 15.2 for the SPX. Third, since the S&P 500 was used in the 2004 article, the authors wanted to use another measure to validate earlier research.

We believe that an expanding level of liquidity (i.e. money) in the economy, combined with a downward trend in interest rates, are major drivers of stock market performance within the four-year presidential cycle. However, the relationship appears to be a lagging one as discussed earlier. Figure 2 shows yearly DJIA growth and lagged interest rates since the 1950s. By lagging interest rates one year, the correlation to stock price behavior becomes more obvious.

The graph shows that within the presidential cycle interest rates tend to go down in advance of the next election. We confirmed this by performing a time-series analysis which shows that, on average, interest rates in the third and fourth year of the presidential period are 0.55 percentage points lower than in the first and second years. (See Appendix 1). Figure 2 also shows that most breaks in the interest-rate reduction cycle occur soon after elections. This is consistent with the notion that right after the elections there can be pressure to raise interest rates to curb any potential inflation. There were a couple of exceptions (1977 to 1980 and 1993 to 1997), but the trend is there. In summary, we provide core evidence of the relationship between changing interest rates and the four year cycle performance.

Figure 2. Dow Jones Industrial Average Growth and Interest Rates across Presidential Periods

Dow Jones Industrial Average Growth and Interest Rates across Presidential Periods

Note: Interest rates are depicted with a one-year lag to illustrate the lagged effect of a given rate on the market.


Figure 2 also depicts the DJIA growth cycle since 1950. Note that in most presidential periods, the valleys in DJIA performance occur in the first and second years of the election periods. There were a few significant exceptions in which performance was higher in the first two years than in the last two (e.g. 1985 to 1988, 1997 to 2000, and 2005 to 2008). Nevertheless, the above facts substantiate the claim in the first article on this topic.[6] More specifically, the stock market typically underperforms in the first and second years of the presidential period, relative to the third and fourth years. To further verify our finding, we performed a time series econometric analysis, which confirms that DJIA growth is on average 7.2 percentage points higher in the third and fourth years of the presidential periods than in the first two years. (See Appendix 2.)

In summary, all of the previous evidence appears to be consistent with our claims: Policies to stimulate the economy as presidential elections approach strongly contribute to the performance of the four-year cycle. Further, there is now sufficient data that the most favorable periods (MFPs) can be validated using two stock market indicators, the SPX and the DJIA. This analysis was also corroborated by showing how the Ulcer Index (i.e. risk) was reflected in the cycles. Finally, Figure 2 shows how the four-year presidential cycle is affected by downward pressure on interest rates.

The 2008 Anomaly

Based on the earlier analysis, it would make sense to invest in the DJIA at the beginning of the favorable period and steer clear of the market during the unfavorable period. This would have been the strategy of choice from 1950 to 2004. However, the negative economic events surrounding the last 2008 presidential election temporarily broke that long-standing trend.

The period from late 2007 through early 2009 was the worst economic crisis the U.S. had seen since the depression of the 1930’s. Like the Great Depression, the 2008 economic environment was an attack on America’s financial structure. There appeared to be at least two core issues that precipitated the most recent economic and stock market upheaval. First, the stock market needs liquidity (i.e. money) steadily flowing through the economy to be profitable. That did not happen in 2008 when several major U.S. banks had to write off large amounts of defaulting mortgage loans. This temporarily dried up liquidity and required immediate Federal Reserve action. Second, the near collapse of the U.S. capital markets spread contagion worldwide. This in turn dramatically slowed economic activity globally, which ultimately put significant downside pressure on U.S. and foreign corporate earnings and both the stock and bond markets.

Because the severity of the 2008 crisis had not been seen during the 1950 to 2004 period, it must be considered an economic and stock market anomaly. Therefore, we do not believe that 2008 is representative of a long-term interruption in the past behavior of the four year presidential cycle. We do believe however, that in an environment with more globally connected financial markets where information flows electronically at a much faster speed, a phenomena that can temporarily break the historically consistent cycle that had existed for 54 years, has been augmented.

Putting the Most Favorable Period to the Test

Because the 2005 to 2008 period is an exception, considering the favorable period of the four-year presidential cycle as an investment strategy should still make sense. Figure 3 shows the current value of a 1953 initial investment of $1,000 based on three investment strategies. Investing in the DJIA during the MFPs and at commercial paper rates during the LFPs yielded a 20,468 percent return. Investing in the DJIA during the LFPs and at commercial paper rates during the MFPs yielded a 519.8 percent return. Investing in the DJIA as a long-term buy-and-hold strategy yielded a 4,408.6 percent return. Notice that the 2005 to 2008 period affected all investment strategies negatively. However, for the MFP investor, the losses from that period were almost completely offset by the gains since the 2009 stock market bottom.

Figure 3: Returns Based on Three Investment Strategies

Returns Based on Three Investment Strategies

Notes. Returns reported include dividends. Investment strategies are:
1. Most Favorable Period Investor: Invests in DJIA during the MFPs and at commercial paper rates during the LFPs.
2. Least Favorable Period Investor: Invests in DJIA during the LFPs and at commercial paper rates during the MFPs.
3. Long-Term DJIA Investor: Invested $1,000 in DJIA in 1953 and has not sold to-date.


Conclusion

The evidence provided in this article shows a propensity for the DJIA to rise during the second half of the four-year presidential cycle. We have discussed why we believe this pattern has been repetitive since 1950. Borrowing from the 2004 study, we adopted the most favorable period within the four year cycle. It begins on October 1 of the second year of the presidential term through December 31 of the fourth year, the favorable period or (MFP). This period performed much better than the unfavorable period, from January 1 in the first year of the presidential term through September 30 of the second year.

However, cycles of any type are not perfectly aligned all the time. This became evident when we attempted to match changes in interest rates and market volatility within the four year cycle. Occasionally this type of market behavior is to be expected and can usually be explained. A recent example is the economic problem in Europe. The point is that there are positive and negative macroeconomic events that can temporarily break a long standing MFP cycle. Even with a history of positive gains in the MFPs from 1950 to 2004, the 2008 market collapse, precipitated by domestic and global economic events, was too powerful for the market to overcome. Although the above was clearly an anomaly, we do not believe it will be the only exception in the future. Globalization and the internet are but two reasons for volatility and uncertainty in the years to come. However, even with the temporary break during the 2008 period, it does not mean that the favorable cycle will not resume. In fact we believe it already has. When we compared the favorable to the unfavorable period for the post 2008 time frame, the DJIA has again performed to date better during the favorable period. In conclusion, we feel that with the advent of merging international markets and modern technology, the more the average investor knows about the interrelationship between politics, economics, and the stock market, the more equipped he or she will be.


Appendix 1

We performed a Prais-Winsten time series analysis of a yearly dataset to account for autocorrelation:

Interest = β1*PresYear + β2 * Inflation + ε, where Interest is the average Federal Funds rate per year; PresYearDummy is a dummy variable with a value of 1 for the third and fourth years of each presidential period, and 0 otherwise; and Inflation is the yearly inflation rate.

The results are:


Appendix 2

We performed a Prais-Winsten time series analysis of a yearly dataset to account for autocorrelation:

ln(DJIA) = β1*PresYear + β2 * GDP + ε, where DJIA is the Dow Jones Industrial Average; PresYear is a dummy variable with a value of 1 for the third and fourth years of each presidential period, and 0 otherwise; and GDP is the real GDP per capita per year.

The results are:





[1] Nickles, Marshall. “Presidential Elections and Stock Market Cycles: Can you profit from the relationship?” Graziadio Business Review, 7 no. 3 (2004). Retrieved from 7(3) http://gbr.pepperdine.edu/2010/08/presidential-elections-and-stock-market-cycles.

[2] McConnell, Campbell, Stanley Brue, and Sean Flynn. Economics, 18th Ed. New York: McGraw-Hill Irwin, (2009), pp. 671 – 679. Also see: Thorbecke, W. “On stock market returns and monetary policy.” Journal of Finance, 52, (1997) 635 – 654. Doi: 10.1111%2Fj. 1540-6261.1997.tb04816.x.

[3] Martin, P.G. and McCain, B.B. “Financial Dictionary,” (2009). Retrieved August 17, 2012 from www.investors.com/Financialdictionary/term/ulcer_index_ui.asp.

[4] Anonymous. “FinancialDictionary,” (2012). Retrieved August 15, 2012, from www.investors.com/FinancialDictionary/Term/Drawdown.asp.

[5] Ibid.

[6] Nickles, “Presidential.”

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Political Connections: The Missing Dimension in Leadership

Early leadership studies examined common traits of successful leaders. Later research focused on combinations of traits as no one profile was shared by all successful leaders. This research focuses on three key dimensions of leadership: charismatic leadership, instrumental leadership, and political connections. It suggests how they can become a scorecard to rate not only one’s chances for advancement, but also one’s bosses and one’s peers.

[powerpress: http://gsbm-med.pepperdine.edu/gbr/audio/winter2010/Article – Political – Chasteen.mp3]

Leadership is one of the most published areas of all business topics[1] because people recognize that it is a key ingredient for successful firms, non-profits, and even countries. Earlier leadership studies focused on leadership traits: What were successful leaders like, and could the duplication of these traits lead to success for other people?[2] However, the trait approach proved insufficient as no one set of traits could be found in all successful leaders.[3]

Later works focused on combinations of traits (2×2 matrices), such as emotional intelligence versus intellectual quotient[4] or charismatic leadership versus instrumental leadership.[5] These were an improvement over using a single dimension as a guidepost, but they still did not tell the complete story. Nevertheless, because 2×2 matrices are easy to present and to conceptualize, they have been featured in many leadership articles, even though they do not give the full picture of what it means to be a successful leader.[6]

A few authors have gone on to examine three or more dimensions, for example, emotional intelligence, intelligence quotient, and technical skills.[7] These can provide more information, but a final consensus has not been reached on what three dimensions are the most important to leadership or if additional dimensions should be considered. The classic Myers-Briggs classification, for example, uses four dimensions: extraversion or introversion, sensing or intuition, thinking or feeling, and judging or perceiving.[8] While more dimensions may be the best approach, more than three can be mentally and conceptually challenging—note that physics uses seven dimensions in a somewhat confusing attempt to explain our origins.[9]

This article focuses on three key dimensions of leadership: charismatic leadership, instrumental leadership, and political connections—”leadership cubed.” It can be considered an improvement over earlier studies that used just two dimensions, and it shows how these three dimensions can be used as a tool for self-assessment. The dimensions were chosen because they combine the attributes of leaders, managers, and networking.

Background

Research has proven that being a charismatic leader is not enough to change an organization over the long term[10] as influence can wear off. Rather, instrumental leadership is needed to make lasting changes.

Instrumental leadership embodies the strengths of charismatic leadership—envisioning, energizing, and enabling—but overlays those assets with elements of behavior reinforcement through structuring, controlling, and rewarding to ensure support for the organization’s ultimate objectives. Structuring refers to building teams with the required competence and empowerment. Controlling refers to creating systems and processes to measure and monitor. Rewarding includes rewards and punishment. These three tasks are not as glamorous as those associated with charismatic leadership, but they represent the hard work required for lasting change.[11]

Charismatic and instrumental leadership can be redrawn as the traditional 2×2 matrix above, which is used in many management studies. Charismatic leadership is needed to generate the initial energy and to create commitment, while instrumental leadership ensures that people continue to act in a manner consistent with these new goals. Leaders can be examined to see where they fit in this 2×2 matrix.[12]

The Leadership Cube

But something is clearly missing from this 2×2 matrix; there are many examples of government and industry leaders who possessed charismatic and instrumental leadership but who failed to make lasting changes to organizations. For example, Colin Powell exhibited great charismatic and instrumental leadership traits, which served him exceptionally well during his early career, but his lack of political support hindered his accomplishments and legacy as U.S. Secretary of State.

Conversely, Condoleezza Rice did not have Colin Powell’s charismatic and instrumental leadership abilities, but her political connections led to longer-lasting accomplishments at the U.S. Department of State.[13] Perhaps a third dimension of political connections, a 2 x 2 x 2 cube, would better explain the lasting impact of successful leaders. In fact, General Electric has adopted such a leadership matrix to allow more variation in selected parameters for company decisions.[14]

Networking and Political Power

Most people have worked at companies where managers who lack technical and organizational skills make it to the top of an organization based on their friendships with those in power. Whether in politics or in organizations, having a connection to those in power can make or break a career. In fact, mentoring and networking are as important in modern organizations as having hard and soft skills. These attributes can be considered the legs of a stool on which to build one’s career.

Power is an omnipresent feature of organizational life. Some researchers consider power the most important factor in explaining how decisions are made in organizations.[15] To be successful in any organization, it is important to have connections to the top decision makers—unless you have the opportunity to demonstrate your skills, you will not advance. You must get noticed by people who can help you navigate the organizational maze, such as a mentor.

leadership 3x3The Leadership Vector

There is one problem that the traditional matrix and the leadership cube share: Traits are scored as either high or low (0 or 1) when, in reality, individuals may fall somewhere in the middle. Likewise, all three dimensions in the leadership cube can be high, low, or medium. Actually, the dimensions really vary anywhere between 0 and 1, such as 0.2, 0.4, 0.7, and so forth.

A better way to present a person’s leadership traits is as a vector within the leadership cube as shown above. The origin is at 0,0,0; high in all three dimensions is at 1,1,1.

Total Leadership Quotient

A person’s leadership quotient can be represented as a set of three numbers, each representing an axis, such as 1.0 for charismatic leadership, 0.5 for instrumental leadership, and 0.5 for political connections. This notation opens up the total inside the cube for a distinct placement of different people. This notation may be harder to draw or conceptualize, but it is a more accurate representation of reality as it allows for an almost infinite set of numbers to measure total leadership potential.

Tool for Self-Assessment

The following table illustrates a possible ranking for various individuals working in the same organization. It shows that the boss is high in charisma, medium in instrumental leadership, and medium in political connections. The two peers have strengths in some areas and weaknesses in others. Worker X is medium in the first two dimensions but needs to work on his political awareness. Such tables can give a heads-up as to where you stand with respect to others in the firm and as to what is required in order to move up in the company.

Leader Charismatic Instrumental Political Connections
Boss 1.0 0.5 0.5
Peer 1 0.4 0.2 0.2
Peer 2 0.1 0.6 0.4
Worker X 0.5 0.7 0.3

Every aspiring leader should try to determine his or her place within the cube and an honest and objective placement is necessary if this self-assessment is to have value. Aspiring leaders should also try to determine the location of their bosses and peers within this cube. Again, honesty and objectivity are necessary if this assessment is to have value. Once these placements are established, one can compare oneself to others in the company.

Conclusion

The leadership cube and its supporting ranking table illustrate:

  1. Traits that made previous leaders successful, and
  2. How individuals rank in these three critical dimensions.

In times of great change, charismatic leadership is necessary; but it is not enough to rely on charisma when effective institutional reorganization is required. This requires charismatic and instrumental leadership as well as political connections, especially as one moves into higher positions of authority.

Good political connections can overcome weaknesses in the other two dimensions, but a lack of political connections can diminish other well-honed leadership skills. This helps explain why some people without charismatic or instrumental leadership skills, but with political connections, still advance in many firms and government offices.

Obviously, fusing all three of these leadership strengths in a person would be optimum to meet the demands of our troubled economy. Unfortunately, a person with all of these attributes is not that common; usually, one is strong in a dimension or two, but not three. However, if you can recognize your standing inside the leadership cube and are aware of how you compare to others, you can strategize to correct those weaknesses. Knowing which goals are most important for oneself and for the organization are the first steps to career advancement.


[1] Tom Peters and Nancy Austin, A Passion for Excellence: The Leadership Difference, (New York: Random House, 1985).

[2] Afsaneh Nahavandi, The Art and Science of Leadership, (3rd. ed.), (New York: Prentice Hall, 2003).

[3] S. Kirkpatrick and E. Locke, “Leadership: Do Traits Matter?” Academy of Management Executive, no. 5 (1991): 48–60.

[4] James MacGregor Burns, Leadership, (New York: Harper Torchbooks, 1978).

[5] David A. Nadler and Michael L. Tushman, “Beyond the Charismatic Leader: Leadership and Organizational Change,” in The Leader’s Companion: Insights on Leadership Through the Ages, ed. J. Thomas Wren, (New York: The Free Press, 1995).

[6] Nahavandi.

[7] Daniel Goleman, Emotional Intelligence: Why It Can Matter More Than IQ, (10th Anniversary Edition), (New York: Bantam Books, 2005).

[8] Sandra Krebs Hirsh and Jean M. Kummerow, Introduction to Type in Organizations, (3rd. ed.), (Palo Alto: Consulting Psychologists Press, 1998).

[9] Terence Witt, Our Undiscovered Universe: Introducing Null Physics, the Science of Uniform and Unconditional Reality, (Indialantic, Florida: Aridian Publishing Corporation, 2007)

[10] Nadler and Tushman.

[11] David Keirsey, Leadership, Temperament, and Talent, (California: Prometheus Nemesis Book Company, 1998).

[12] Gary Yukl, Leadership in Organizations, (7th. ed.), (New York: Prentice Hall, 2010).

[13] Larry Chasteen, “The Leadership Cube: Examples in the US Government,” Journal of Practical Leadership, 4, no. 1 (2009): 86–94.

[14] Gregory G. Dess, G.T. (Tom) Lumpkin, Alan Eisner, Strategic Management: Creating Competitive Advantages, (New York: McGraw-Hill/Irwin, 2008). (hyperlink no longer accessible).

[15] Peters and Austin.

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