- Federal politics and President Trump continue to be the sun the news cycle revolves around.
- Since 1950, the S&P 500 has had a positive return in the 12 months following the midterm elections during all 17 election cycles.
- A strong economy, in theory, could mean more votes, and that re-emerged focus is reflected in stock performance.
Federal politics and President Trump continue to be the sun the news cycle revolves around. The question for investors, though, is whether they also represent the sun the market revolves around—or at least reacts to. This is not a novel theory, nor is it specific to our current President. It’s often said that election cycles are a predictable driver of the market regardless of who’s occupying the White House, much less what news and policies they are generating. The theory was coined by Yale Hirsch, an author and stock market historian, and is usually called the “Presidential Election Cycle Theory."
In a nutshell, the Presidential Election Cycle Theory posits that the first two years after any given federal election will be weaker than the two that follow. The logic behind the theory is relatively simple. Following the election of a new president, the focus is thought to be more on fulfilling campaign promises than necessarily fueling the economy—though of course those two categories can overlap. In the second half of a presidency, the economy takes center stage again as the candidate shifts back to campaign mode. A strong economy, in theory, could mean more votes, and that re-emerged focus is reflected in stock performance.
Numerous data points support the idea that there is a link between stock market cycles and election cycles. According to peer-reviewed research, between 1942 and 2002, there were fifteen stock market cycles, each lasting four years on average. Since the 1920s, the Dow has only risen at a 1% average growth rate the two years after an election, but has grown at a nearly 16% year the two years leading up to the next one—and the trend has grown “more pronounced with time,” according to academic research. The same paper, at the time of publication, showed that the market had risen in each of the last thirteen “third years” of the cycle—the year we are currently in.
The theory is contested, though; the presidencies of Barack Obama and Bill Clinton, for instance, are often cited as notable outliers. In each presidency, stocks came out the gate quite strong. On top of that, the bloodbath that followed last year’s midterm election didn’t follow a typical pattern. Midterm election years generally experience a flat or negative market heading into November but then end the year with a strong rally into the year’s end. The pattern held up in 2016; the S&P 500 fell for more than a week straight heading into Election Day, then rallied over 5 percent through Dec. 31.
Yet in 2018, the precise opposite happened. The S&P 500 moved steadily higher during the first three quarters of the year, but came crashing back to earth during the final three months of the year thanks to a trade war with China, rising interest rates from the Federal Reserve, and a prolonged government shutdown. In the end, stocks posted their worst year in a decade, with the S&P 500 and Dow falling for the first time in three years.
Of course, market corrections are also a normal and an expected part of equity investing; that’s the whole point of stocks—that higher volatility breeds long-term gains. In fact, the S&P 500 has experienced over 20 drawbacks of more than 5% since the financial crisis. During the first 22 of those drawbacks the average pullback was just over 9% and lasted 42 days.
But in all of them, the market has recovered and hit new highs.
Could stocks now be poised to regain last year’s losses, since the third year of any given presidency is said to be the strongest? Both recent market volatility and the Presidential Election Cycle Theory suggest some relief is ahead. Of course, one could make the case that the economy has in fact been a core campaign promise of President Trump, so the very dichotomy the theory is built on doesn’t hold up to scrutiny. Still, considering the fact that the anticipated strength of the third year of this presidency comes in conjunction with other positive forces and some already-regained momentum, there’s at least reason for optimism.
Since 1950, the S&P 500 has had a positive return in the 12 months following the midterm elections during all 17 election cycles. And so far, things look good: the S&P 500 has already gained 12% in 2019 alone and 8% in the last 12 months despite the aforementioned fourth-quarter woes. The fourth-quarter headwinds that battered stocks are largely dissipated, too. The government shutdown is over and, while investors panicked over rising interest rates late last year, the Fed has notably changed its tune. It left interest rates unchanged last week and alluded to the fact that we could go the whole year without another hike. Some hurdles and headwinds naturally remain, but the fact that the overall election pattern of the stock market is being bolstered by other promising indicators could help fuel it into reality.
This article was written by
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