It's that time of year when financial pundits of all stripes make predictions about the coming year. Some financial market commentators are using the 3rd year of the presidential cycle as an underpinning to a positive year for stocks in 2011. I thought I’d put that thesis to the test.
The table above shows year over year returns for the 3rd year of the presidential cycle since 1950 for the S&P500. Remarkably it had been positive 15 out of 15 times with an average gain of more than 18%. I guess that means we should go all in next year. After all, it has a perfect record. However before we carried away, lets extend the data back further using the DJI index since equivalent data for the S&P500 is not available (to me at least).
The DOW gives us an extra five data points extending the sample to 20. The record is still impressive but now includes the meltdown of 1931 and a small decline in 1939. Still, the average return at just over 13% is significantly better than the long term average of about 9% excluding dividends.
So the odds seem to be with us, but lets look a little deeper into the data. As we know, 2009 and barring a catastrophe in the next few days, 2010 have been positive years. So how has the 3rd year of a presidential cycle typically performed after rising in the prior two years?
The returns are much closer to the long run average at 10.4% however the main problem with this analysis is that it only yields 4 data points when using the S&P500 (note that I have assumed that 1949 and 1950 were positive for the S&P500 since the DOW had gains of 13.1% and 17.4% respectively). Also consider that returns in 1987 and 2007 were sub-par and that the best performance was during the bubble era of the late 1990′s.
Another problem is looking only at year end levels as it ignores the volatility that can happen in between. For example the S&P500 closed up 2.0% in 1987 but that ignores the 3 month plunge of more than 30% from August to October. Bill Hester of Hussman Funds pointed out back in 2005 that the 12-month period beginning in October of the second year of the presidential term has enjoyed average total returns of more than 28 percent, on average (The S&P500 is currently up approximately 10% since the beginning of October 2010).
So where does that leave us? I would argue nowhere closer to determining what market returns will be in 2011. If this seems like it has all been an exercise in futility, I won’t argue with you. Any prediction about the future of the market should be taken with a grain of salt, despite the seemingly strong historical evidence the 3rd year of a presidential cycle presents.
