Patterns. They're everywhere. In the world of finance, traders, portfolio managers, and investors are always looking for an edge somewhere. Maybe it's a new technical indicator someone created, or a head-and-shoulders chart pattern. Even in the realm of infinitely small time horizons, high frequency traders look for patterns and employ game theory to make a buck. Today, there is one much debated pattern that remains intact, suggesting stocks could see another rally into next year.
It's called the presidential cycle. It's an analysis of stock market performance compared to the presidential and annual calendar cycles.
Algorithmic investing and using market statistics to capture short-term abnormalities has been an area long dominated by the ultra-high speed, high frequency traders. Those traders may be able to dominate the field on a daily basis with their computational power, but the extremely low frequency anomaly of the calendar offers an opportunity that those traders can't whisk away.
The annual calendar cycle is broken into two pieces, the weak period and the stronger period. The weak period runs from May to October, while the strong period runs from November to April. The annualized returns for each period are 6.8 percent and 13.4 percent, respectively.
Breaking down the four-year presidential cycle into each year, the result is a post-election year, a mid-term year, a pre-election year, and an election year. Each year can then be summarized by its annual calendar cycle. An interesting observation is that the mid-term election year is historically the weakest year for the stock market. Combined with the annual calendar cycle, the current six-month window is the weakest time for the stock market, with an average annual return of approximately one percent.
Next up, is the strong portion of the calendar cycle, the time from November to April. Coincidentally, going into a pre-election year during the strong cycle also produces the strongest historical returns for the stock market with an average annualized return of almost 25 percent.
Policy Driven Returns
The reason for this very low frequency correlation between stocks and politics is due to presidential behavior after taking office, according to a research study at Pepperdine University. Once elected, a president realizes that in order to keep their job in four years they need to have an economy that is as healthy as it can be. From day one, they work to put in place fiscal policies that are aimed to improve the current economic situation. They will do this by raising or lowering taxes and increasing or decreasing government spending.
The Federal Reserve may even play a role in the president's efforts by raising or lowering interest rates which increases or decreases the nation's money supply. If the Fed employs a loose monetary policy, the typical impact would be a rising inflation. Conversely, tight policy should cause inflation to fall.
As time moves forward and we approach the strongest historical time period to be an investor, the same levers typically used to boost returns and make the economy look healthy are the same ones that have been pushed all the way to their limits.
Interest rates are at all-time lows, and the Fed is slowly tapering its bond buying. Only the Fed knows what it will do in the future, but one thing is for sure. Rates can't go any lower. This doesn't bode well for the stock market as it enters into what should be a very strong historical time period because the gas pedal is already pressed to the floor.
It has been well covered by reporters that the current bull market is in its late stages and could be facing a strong correction or bear market soon. If interest rates rise in the near term this could be a possibility, but Fed Chairwoman Janet Yellen is as dovish as they come. Inflation concerns are subdued and with the geopolitical tension in Ukraine, Russia, Syria, Iraq, and Israel, it's unlikely the Fed will make any extreme policy decisions in the near term that could potentially undo all of the progress the economy has made.
Thomson Reuters recently reported that vice chairman of the $10.5 billion hedge fund Omega Advisors, Steve Einhorn, believes that there is plenty of upside in the stock market. "I don't think this bull market is over," Einhorn said. "I think there is still a good deal of time and price left in it, though I would say that given the advance we have made year-to-date, that the upside between now and year-end is respectable but not anything other than respectable."
Don't Fight the Fed, and Don't Fight the Trend
As the mid-term elections arrive, the pre-election year market strength is a trend to acknowledge in the coming months. Its absence of traditional chart patterns and fundamental ratios makes it a catalyst worthy of consideration given a status quo fiscal policy from Washington and the Fed.
Investors should use the recent market decline to reassess equity holdings and position investments to take advantage of a likely move higher in equities. Investors with an inclination toward advanced strategies should consider using options to protect or buffer holdings from potential market missteps.
Regardless of how an investment is structured, the key to success over the next year will be vigilance. Vigilance towards individual stock risk, geopolitical events, the mid-term elections, and the Fed.
Don't be fooled and buy into the sensational media hoopla. At least until April of 2015, it's time to be buying stocks.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.