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
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
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
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) https://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.”