petersasaki's  Instablog

Previously, we discussed tactical considerations regarding the presidential election. Today, we will review the broader trends around electoral cycles. One question making the rounds is what election years mean for market expectations. Given that economic issues drive much of politics, especially in peacetime, surely who wins the presidential elections should have some short-term effect on market performance.

After looking at the historical record, however, the quick answer to this question would seem to be "no." Election results have little net effect on short-term market returns, but the electoral cycle has a striking impact on the risk-reward ratio. The long-term effects that policies resulting from the election have on growth, profits, prices and risk will take place, as indicated, over the long term. So, on average, election day is no magic dividing line for making investment decisions.

Indeed, the data show that the beginnings of administrations tend to be lackluster on a risk-return basis, although there is still considerable variation from cycle to cycle. Another way to think about this is simply to say that traditional investing considerations like value, momentum and the economic cycle are likely to be more influential than the electoral cycle.

What Does the Data Show?

Figure 1 looks at total returns constructed from Professor Robert Shiller's public data on monthly S&P 500 prices and dividends, broken down by calendar quarters into the electoral cycle (cycle-quarters). Shiller's sequence goes back as far 1871. Although the S&P 500 index was introduced in 1957, Shiller has developed a widely accepted method to estimate equivalent index values before 1957.

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The figure shows the median, interquartile range and full range of quarterly returns, broken down by the number of quarters that have passed since the last presidential election. Quarter zero is the quarter in which a presidential election takes place, quarter 1 is the January-March quarter immediately following that election, and quarter 15 is the last full quarter (July―September) before the next presidential election. For reference, dotted vertical lines indicate the start of calendar years. Horizontal lines mark the mean (2.82%, red) and median (3.25%, green) returns over all quarters considered.

Because of extreme outlier returns at the start of the Great Depression (between 1929 and 1933), Figure 1 only shows years since 1934, producing roughly 20 returns per cycle-quarter. Including data before 1934 does not change the results or appearance substantially, other than adding a few outliers, changing the vertical scale and thus making differences harder to read.

What we see in Figure 1 is that the quarter of an election has historically had a median return slightly higher than the overall median (and mean) over time, perhaps reflecting optimism for the possibilities of policy change or continuity. The interquartile range is also smaller, suggesting that there is less volatility after an election, at least in normal times (the wide total range is explained by the fourth quarter of 2008, during the financial crisis).

Figures 2 and 3 show the effect of the electoral cycle in starker terms. Figure 2 calculates excess returns (total return - quarterly return on cash, proxied by 1-year Treasury rates) for each quarter of the cycle, showing their mean and standard deviation over roughly 20 election cycles. Excess return calculations are helpful because these long histories include times of both high and low inflation; during high inflation, the rates on cash/short-term Treasurys rise, and so some of a stock's quarterly return might simply be compensation for inflation figures. Using excess returns helps control for that, as well as focusing on how stocks compensate for investment risk.

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Two things stand out in Figures 2 and 3. First, the volatility of quarterly returns notches up when a presidential election occurs and then trends slowly downward over the term. The trend notwithstanding, there is a noticeable uptick in volatility in quarter 7, just before midterm congressional elections. Once the elections have taken place, volatility reduces its downward trend.

Second, there is a dramatic difference in returns between the first and second halves of a presidential term, with the second half contributing substantially stronger and more consistent returns than the first. This difference is noticeable in the returns line in Figure 2 but stands out even more in Figure 3, which computes annualized Sharpe ratios for returns in each quarter of the electoral cycle. Sharpe ratios capture the average return for the level of quarterly risk.

One might initially suspect that this pattern is an artifact of outliers from the recent crisis, but remember that these figures are aggregated across 20 electoral cycles since 1934, so the effect of any one administration is relatively small. The pattern can also be seen in Figure 1 in the size and location of the interquartile boxes, which are less sensitive measures to individual outliers.

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In addition, this administration's record beats the average handily over the first half of its term and performs fairly well in the second. Figure 4 plots the growth in the S&P 500 total return index over the Obama administration cycle (Q4 of 2008 through Q3 of 2012) in relation to these historical averages.

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This cycle has delivered an average of 2.51% total (excess) return per quarter, as opposed to 1.67% during a typical cycle. If we drop quarter 0 from these averages (because Obama was not yet in office in 2008 and data is not yet in for 2012), this cycle has delivered an average of 4.15% more than Treasurys versus 1.73% historically. Much of this administration's divergence may have to do with the Fed's quantitative easing program, and the U.S. debt ceiling crisis in 2011. Whether this performance can be attributed directly to the President is a much more complex question. However, this last cycle has certainly not conformed to the average.

Testing the reason this pattern exists is difficult. At the same time, speculation is irresistible. It could very well be that the presumed "mandate" behind a Presidential election drives policy changes, and this introduces additional uncertainty into economic, regulatory and financial expectations. This dissipates over time as the process gets revealed, producing mildly declining volatility. Midterm elections seem to serve as a kind of a "referendum on the mandate," adding or removing "gas" to the policy engine as desired. The uncertainty in the quarter immediately before the election creates a spike in volatility. Once the policy direction is set in the first half of the election cycle, and the level of support/opposition to that policy determined at the midterm, the second half of an administration's mandate may be easier to understand and generate better risk-return ratios than the first.

Conclusions

If the historical pattern holds, it suggests that volatility will pick up after the election and that the first two years of any administration are good times to ratchet down equity exposure, because the return to equities over simply holding cash is very low in comparison to the level of risk.

However, even though the risk-reward ratios are low during the first half of a presidential term (indeed statistically indistinguishable from 0), it is important to remember that the range of possible returns is still quite wide, and so the standard metrics such as valuation, growth, and stage of the economic and business cycle are still very important. Trimming equity exposure makes strategic sense here, but eliminating it is overkill.

In addition, tactical decisions may also be relevant given the unique characteristics of any one electoral cycle. We discussed some of those tactical considerations in our last blog. Certainly the last electoral cycle did not match.

There are obviously more variations to consider, such as performance in first term versus a second term, the performance of Republican vs. Democratic administrations, performance where there is continuity in party control versus party change, and others. We may address some of these features in future pieces.

Disclosures & Disclaimers Securities offered through Registered Representatives of Centara Capital Securities, Inc., Member FINRA/SIPC, and Centara Insurance Services. CA Insurance Lic. #0F30702. Investment advisory and financial planning services offered through Centara Capital Management Group, Inc., a Registered Investment Advisor. CA Insurance Lic. #0D85861. Legal services provided by Centara Legal Group, APC, David J. Gebhardt, Principal. None of the information presented is to be construed as investment advice. See a prospectus before investing. This commentary is provided for educational purposes only. The information, analysis and opinions expressed herein reflect our judgment as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation. All investments carry a certain risk and there is no assurance that an investment will provide positive performance over any period of time. Information obtained from third party resources are believed to be reliable but not guaranteed. Past performance is not indicative of future results. This document has been provided specifically for the use of the intended recipient only and must be treated as proprietary. It may not be passed on, nor reproduced in any form, in whole or in part, under any circumstances without express prior written consent from Centara Capital. This document is provided for information purposes only and does not constitute an invitation, solicitation or offer to subscribe for or purchase any of the investments, products or services mentioned herein, nor shall it, or the fact of its distribution or communication, form the basis of, or be relied on in connection with any contract. Potential investors in any investments, products or services referred to in this document or to which this document relates should seek their own independent financial, legal and taxation advice. This document is not intended to provide a sufficient basis on which to make any investment decision. The information, data and opinions contained in this document are for background purposes only, are not purported to be full or complete and no reliance should be placed on them. Centara Capital believes (but has not necessarily verified) that the sources of the information, data and opinions contained in this document are reliable. However, neither Centara Capital nor any of its affiliates gives any guarantee, representation, warranty or undertaking, either express or implied, regarding and accepts no liability, responsibility or duty of care for, the accuracy, validity, timeliness or completeness of any such information, data or opinion (whether prepared by Centara Capital, any of its affiliates or by any third party) or that it is suitable for any particular purpose or use or it will be free from error. To the extent that any further information, data or material is provided in relation to the investments, products or services referred to herein, no representation is made that any such further information, data or material will be calculated or produced on the same basis, or in the same format, as contained in this document. No obligation is undertaken to update any information, data or material contained herein. Certain information contained in this document may be "forward-looking statements", which can be identified by the use of forward-looking terminology such as "may", "will", "should", "expect", "anticipate", "project", "estimate", "intend", "continue", "target", "believe", the negatives thereof, other variations thereon or comparable terminology. Due to various risks and uncertainties, actual events, results or performance may differ materially from those reflected or contemplated in such forward-looking statements.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Economic recoveries hinge on the interplay of three factors:

1. The economy's organic capacity to reorganize and heal itself.
2. Monetary policy, usually implemented a central bank (e.g., the U.S. Fed, the European Central Bank).
3. Fiscal policy, as implemented by governments

Ultimately, the first item (organic reorganization) is the main determinant of a recovery's pace and scale, but fiscal and monetary policy can help smooth or hinder the way.

These last two factors also have the advantage of being public policy tools, and therefore are points where human decisions and actions can have an effect on the economy. In an election season during a recession or weak recovery, how these tools should be used is inevitably a hot topic.

Monetary Policy

Monetary policy is primarily about the quantity of money and credit in the economy and the ease with which consumers, businesses and governments can access it. If money is too tight or difficult to access, goods and services cannot move quickly or effectively to where they are needed, and business investment is held back for lack of capital. These constrictions put a chill on business activity, growth and employment, as well as slowing any economic restructuring.

If monetary policy is too loose, then consumers are easily induced to spend beyond their means and investors are drawn to projects of questionable value or with questionable rates of return (because it is easy to rationalize frivolous investments or paper over mistakes or with further borrowings). In addition, inflation can start to pick up if the growth of money and credit outpaces the growth of the real economy (though this is also mitigated by monetary velocity, or the rate at which people let current savings and credit turn into purchases or investments).

Monetary policy can have a powerful effect on the economy, much like adding or withholding fuel and oxygen from barbeque coals in order to get the heat just right. Its biggest weakness, however, is that it is a blunt instrument. Monetary policy cannot effectively target specific segments of the economy, and so recessions that are about more than cyclical overproduction and inventory clearing often cannot be addressed efficiently by monetary policy alone. (The financial sector is an exception to this rule because many central banks also have regulatory roles over financial institutions and therefore some capacity to target actions more specifically within the financial sector.)

Fiscal Policy

Fiscal policy is the only tool that can genuinely target specific economic actors and sectors. Fiscal policy has three main components:

1. Government expenditures, including direct government purchases, transfer payments (e.g., welfare), and subsidies to individuals, businesses and sectors.
2. Tax policy, including general tax rates and their progressive or regressive features, tax exemptions, credits and deductions, and tax holidays.
3. Government deficits (or surpluses): The difference between government expenditure and tax receipts must be borrowed.

A full economic policy typically includes components for regulatory policy as well, but fiscal policy is, strictly speaking, about how government manages its taxing, spending and borrowing powers. Every government needs to tax, spend and/or borrow simply to function as an organization and pay its staff. Still, most modern governments also design fiscal policies with larger economic objectives in mind.

Unlike monetary policy, fiscal policy can be targeted to specific groups and parts of the economy that require special attention. A government can, for example, increase its purchases from small business directly; spend more on military procurement; offer tax breaks for companies that hire in economically depressed areas; fund basic research; subsidize worker training by universities or companies to create a more flexible workforce; extend or contract unemployment benefits; or any of a multitude of other policies. The key is that fiscal policy can carefully specify the eligibility for economic assistance or penalties and therefore target specific areas that monetary policy is always not able to reach.

Fiscal policy is a double-edged sword. On the plus side, if there is a clear skills mismatch in the labor force, fiscal policy can make it easier to train and hire people who are leaving old industries and seeking new ones. If there are areas where the country has a clear comparative advantage but needs to upgrade its fixed asset base, fiscal policy can make that easier and faster. The downside is that the line between responsible fiscal policy and simple pork-barrel politics can be extremely blurry and stimulative efforts-whether through spending increases or through tax cuts-tend to push government deficits and total debt upwards. Stimulation in hard times needs to be accompanied by serious debt reduction in good times, and elected officials seldom want to be seen reducing benefits even after a crisis has passed.

Industrial policy, where countries target specific industries to support is one fiscal approach many countries use. China, Brazil, and India and Russia have all used industrial policy to become major powers in the emerging world, and this may be a model with renewed importance. On the downside, many governments' record of picking winning versus losing industries is spotty at best, and the close ties that develop between a subsidized industry and government mean that it can be difficult to disengage these favors when needed. Industrial policy does seem to work better when countries are playing "catch-up" as opposed to solidifying a dominant position. Countries in dominant positions tend to benefit more by engaging in basic research that may spawn future innovations.

Our Current Challenges

One of the challenges of the current crisis in the U.S. is that monetary policy has been stretched to its limits, and it is not clear how much more can be achieved with monetary policy alone. The so-called transmission mechanism that converts the Fed's policy easing into available credit for businesses to expand and hire is not functioning well. People debate the reasons-uncertainty over taxes and regulation, consumer demand and deleveraging, etc. One key factor is that banks are still repairing their balance sheets and therefore demanding higher lending spreads than borrowers are currently willing to stomach. Until banks have substantially larger capital cushions, it is hard to imagine them lending much without substantially better interest rate spreads, which is what leads many to describe the Fed's monetary easing as being as effective as "pushing on a string."

At the same time, paralysis in Congress has essentially frozen fiscal policy. Monetary policy is mired in bank balance-sheet restructuring, and if businesses are to find ways to innovate and/or expand, they either need to wait until consumers deleverage and can spend again, or they need stimulus from the only other sources available: fiscal stimulus at home and exports to markets abroad.

Between the "pushing on a string" of monetary policy, and the deficit debate hampering fiscal policy, options to promote recovery are slimming fast. It seems clear to us, however, that fiscal policy is the only approach that has much chance of working going forward. The dangers of deficit spending are real, but it is already clear that existing deficits will be unsustainable unless enduring local growth can be re-ignited. Generating more secure employment at home, matching labor force skills to the changing needs of the domestic marketplace and expanding the activities of small businesses are all policy targets that demand the fiscal toolbox, not the monetary one.

Monetary policy can assist with fiscal policy by ensuring an environment in which fiscal policies can be funded at low interest rates. We believe Fed Chairman Ben Bernanke has been signaling his willingness to support more fiscal policy through quantitative easing, as well as through his Congressional testimony, in which he himself acknowledges that there are limits to what monetary tools can accomplish. Congress has been loath to take the hint so far, but we think they need to listen.

Disclosures & Disclaimers Securities offered through Registered Representatives of Centara Capital Securities, Inc., Member FINRA/SIPC, and Centara Insurance Services. CA Insurance Lic. #0F30702. Investment advisory and financial planning services offered through Centara Capital Management Group, Inc., a Registered Investment Advisor. CA Insurance Lic. #0D85861. Legal services provided by Centara Legal Group, APC, David J. Gebhardt, Principal. None of the information presented is to be construed as investment advice. See a prospectus before investing. This commentary is provided for educational purposes only. The information, analysis and opinions expressed herein reflect our judgment as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation. All investments carry a certain risk and there is no assurance that an investment will provide positive performance over any period of time. Information obtained from third party resources are believed to be reliable but not guaranteed. Past performance is not indicative of future results. This document has been provided specifically for the use of the intended recipient only and must be treated as proprietary. It may not be passed on, nor reproduced in any form, in whole or in part, under any circumstances without express prior written consent from Centara Capital. This document is provided for information purposes only and does not constitute an invitation, solicitation or offer to subscribe for or purchase any of the investments, products or services mentioned herein, nor shall it, or the fact of its distribution or communication, form the basis of, or be relied on in connection with any contract. Potential investors in any investments, products or services referred to in this document or to which this document relates should seek their own independent financial, legal and taxation advice. This document is not intended to provide a sufficient basis on which to make any investment decision. The information, data and opinions contained in this document are for background purposes only, are not purported to be full or complete and no reliance should be placed on them. Centara Capital believes (but has not necessarily verified) that the sources of the information, data and opinions contained in this document are reliable. However, neither Centara Capital nor any of its affiliates gives any guarantee, representation, warranty or undertaking, either express or implied, regarding and accepts no liability, responsibility or duty of care for, the accuracy, validity, timeliness or completeness of any such information, data or opinion (whether prepared by Centara Capital, any of its affiliates or by any third party) or that it is suitable for any particular purpose or use or it will be free from error. To the extent that any further information, data or material is provided in relation to the investments, products or services referred to herein, no representation is made that any such further information, data or material will be calculated or produced on the same basis, or in the same format, as contained in this document. No obligation is undertaken to update any information, data or material contained herein. Certain information contained in this document may be "forward-looking statements", which can be identified by the use of forward-looking terminology such as "may", "will", "should", "expect", "anticipate", "project", "estimate", "intend", "continue", "target", "believe", the negatives thereof, other variations thereon or comparable terminology. Due to various risks and uncertainties, actual events, results or performance may differ materially from those reflected or contemplated in such forward-looking statements.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Last month, the Fed announced that it had decided to undertake a third round of quantitative easing: the much anticipated QE3. Unlike previous measures, this third action has no listed expiration date. The Fed stated its medium-term intention of buying another $40 billion per month of Treasury and agency mortgage-backed securities, with the stipulation that more might come later, if needed.

The fact that there is no listed expiration date has led many analysts to call this round of quantitative easing "QE-infinity." We personally find the term Endless QE more poetic.

On October 1, 2012, Chairman Bernanke gave a speech at the Economic Club of Indiana, entitled "Five Questions about the Federal Reserve and Monetary Policy." In it, he defended his actions and explained the reasons for QE3. He also stated that as long as inflation remains low and unemployment high, the Fed will do whatever it can to get the economy, and particularly employment, growing.

Chairman Bernanke argued that QE policies became necessary after 2008 because the traditional methods of lowering short-term interest rates cannot push [nominal] interest rates lower than zero. By extending monetary policy to lower rates farther out on the yield curve, along with assurances to, "keep rates low for extended periods of time," the Fed hopes to keep interest rate expectations and borrowing costs low.

Second-Guessing the Fed

There is a cottage industry of financial professionals dedicated to telling the public what Chairman Bernanke is doing wrong, what he doesn't get about the economy, and why QE 1, 2, 3, etc. will fail and ultimately result in substantial inflation. It is not at all clear, however that most of these authors understand either economic theory or economic history as well as the Chairman does, or even how to do rigorous comparisons of cause and effect. Indeed, some of these author's statements seem more about proving to others that they actually remember something about undergraduate economics than offering serious thoughts about what options a central banker has in the current economic doldrums.

The idea that Chairman Bernanke does not know about the equation of exchange or that excessive monetization of assets has caused inflation in other circumstances is, quite frankly, preposterous. Bernanke and his team have a more complete picture of the economy than almost anyone else, including proprietary information on banks, employment, and GDP growth that only the government can collect.

This is not the same as saying that the Fed's actions do not have risks, including future inflation, depression, or stagflation, or that we can know whether the economy will fire up and start producing both jobs and growth before serious inflation occurs. Bernanke has simply implied that while employment growth and core measures of inflation remain below 3%, the Fed will err on the side of risking higher inflation over risking recession or depression.

Will the Measures Work?

We will never know whether Endless QE works, simply because we cannot run repeatable experiments. To the extent that rapid inflation does not appear, we can at least say that it did not provoke disaster.

At some point in the future, perhaps inflation will tick up, but higher energy and food prices have as much to do with global demand for fuel and low crop yields as it does with monetary policy. Japan has pursued its own QE policies for two decades without much growth or inflation, so despite the seeming law-like nature of the equation of exchange (MV=PY), inflation is not a foregone conclusion of the Fed's actions. Indeed, while the labor market remains depressed and core inflation remains around 2%, it is hard to argue that employment shouldn't be the priority.

There is a problem with what central bankers call the "transmission mechanism" by which lower interest rates lead to greater credit availability and spending, production growth, and therefore employment. Currently, the money that the Fed makes available to banks is not lent to businesses that hire more workers and restart the economy.

Portfolio Implications

The challenge for the economy is a precarious balance. Without enough support from fiscal or monetary policy, we will have recession and even deflation, but if the economy grows rapidly and the Fed is unable to reverse its quantitative easing smoothly, we will have inflation, and the Fed's cure for that will likely bring recession.

What we are likely to see in asset markets is something similar to "risk-on/risk-off," but is really more akin to "inflation-expectation-on/inflation-expectation-off." The right strategy is to have two portfolios, one designed to outperform the market with inflation and another designed to outperform the market with deflation. As sentiment oscillates between one view and the other, the negative correlation between these portfolios should smooth out volatility even as the assets grow over time. Eventually, one view (inflation or deflation) will dominate, and a portfolio manager can shift accordingly.

In a deflationary scenario, fixed-rate bonds, income-producing assets, mature firms, consumer staples, and utilities are expected to be the most valuable. In inflationary times, energy, metals, and real estate are expected to perform better. Many people say that stocks perform well in inflationary environments, but this is only true once inflation is already established. In the jump from non-inflation to inflation, stocks are likely to fare poorly. Similarly, commodities are thought to be good in inflationary times, because they represent real assets; however, agricultural commodities are sensitive to input prices, and so are not necessarily as inflation-hedging as non-renewable and/or more-easily stored commodities.

All of this suggests the importance of diversification (across both sectors and asset classes), but it is a more nuanced kind of diversification.

Disclosures & Disclaimers

Securities offered through Registered Representatives of Centara Capital Securities, Inc., Member FINRA/SIPC, and Centara Insurance Services. CA Insurance Lic. #0F30702. Investment advisory and financial planning services offered through Centara Capital Management Group, Inc., a Registered Investment Advisor. CA Insurance Lic. #0D85861. Legal services provided by Centara Legal Group, APC, David J. Gebhardt, Principal. None of the information presented is to be construed as investment advice. See a prospectus before investing.

This commentary is provided for educational purposes only. The information, analysis and opinions expressed herein reflect our judgment as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation. All investments carry a certain risk and there is no assurance that an investment will provide positive performance over any period of time. Information obtained from third party resources are believed to be reliable but not guaranteed. Past performance is not indicative of future results. This document has been provided specifically for the use of the intended recipient only and must be treated as proprietary. It may not be passed on, nor reproduced in any form, in whole or in part, under any circumstances without express prior written consent from Centara Capital. This document is provided for information purposes only and does not constitute an invitation, solicitation or offer to subscribe for or purchase any of the investments, products or services mentioned herein, nor shall it, or the fact of its distribution or communication, form the basis of, or be relied on in connection with any contract. Potential investors in any investments, products or services referred to in this document or to which this document relates should seek their own independent financial, legal and taxation advice. This document is not intended to provide a sufficient basis on which to make any investment decision.

The information, data and opinions contained in this document are for background purposes only, are not purported to be full or complete and no reliance should be placed on them. Centara Capital believes (but has not necessarily verified) that the sources of the information, data and opinions contained in this document are reliable. However, neither Centara Capital nor any of its affiliates gives any guarantee, representation, warranty or undertaking, either express or implied, regarding and accepts no liability, responsibility or duty of care for, the accuracy, validity, timeliness or completeness of any such information, data or opinion (whether prepared by Centara Capital, any of its affiliates or by any third party) or that it is suitable for any particular purpose or use or it will be free from error. To the extent that any further information, data or material is provided in relation to the investments, products or services referred to herein, no representation is made that any such further information, data or material will be calculated or produced on the same basis, or in the same format, as contained in this document. No obligation is undertaken to update any information, data or material contained herein. Certain information contained in this document may be "forward-looking statements", which can be identified by the use of forward-looking terminology such as "may", "will", "should", "expect", "anticipate", "project", "estimate", "intend", "continue", "target", "believe", the negatives thereof, other variations thereon or comparable terminology. Due to various risks and uncertainties, actual events, results or performance may differ materially from those reflected or contemplated in such forward-looking statements.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.