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Whether Mitt Romney or Barack Obama win the election, the markets will likely underperform during the first two years of their term and outperform in the last two, the Presidential Cycle shows. (POOL/REUTERS)
Whether Mitt Romney or Barack Obama win the election, the markets will likely underperform during the first two years of their term and outperform in the last two, the Presidential Cycle shows. (POOL/REUTERS)

Inside the Market

The Presidential Cycle: Whoever wins, markets lose Add to ...

Regardless of who wins the White House in the U.S. presidential election, the stock market faces enormous challenges in the year ahead.

Earnings are struggling, the United States is facing a “fiscal cliff” of rising taxes and reduced government spending, Europe is mired in recession and China is slowing down.

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Even worse, the Presidential Cycle looms large.

At least, that’s the theory. Stocks tend to move in a bizarre pattern with the four years of a U.S. presidential term – where years one and two tend to be the worst for stock market performance, while years three and four tend to be the best.

If you suspect this observation is the stuff of dreams by the folks at the Stock Trader’s Almanac, you’re partly right: They discovered the trend in the 1960s.

But since then, the cycle has aroused the curiosity of academics and investors who can’t resist the logic – and alluring numbers – of the underlying pattern.

U.S. presidents get down to business in the first half of their terms, often with policies that are not conducive to market gains. Researchers at the Tinbergen Institute for economic research found that the S&P 500-stock index has underperformed during these years, according to data going back to 1948.

In the second half of their terms, U.S. presidents tend to focus on re-election prospects, juicing the stock market in the process. The Tinbergen researchers found that in these years, the S&P 500 outperformed by an average of 9.8 per cent.

The effect can also be seen in the bond market, where credit spreads widen in the early years of a presidential term and shrink in the third.

"We conclude that the presidential cycle effect in U.S. stock and bond markets is a robust phenomenon," the researchers said.

The problem is that no one can provide a really good reason the phenomenon exists.

"You can weave a story if you slice the data," said Rossen Valkanov, professor of finance at University of California at San Diego. "It is hard to invest based on that. It's an event that happens once every four years. From an investment perspective, you need something that happens more frequently."

That doesn't hold back Jeremy Grantham, chairman of global asset manager GMO LLC. He is one of the biggest proponents of the presidential cycle - and with $99-billion (U.S.) in assets under management, when he says that the start of a new cycle is reason enough to lie low over the next year, people tend to listen up.

"History is quite clear," he told Forbes magazine recently. "There has been, on average, no money made in year one and two after a presidential election going back to 1932, after you adjust for inflation. All the money is made in year three with an adequate return in year four."

Myles Zyblock, chief investment strategist at RBC Dominion Securities, ran some numbers to back up this claim, using data going back to the Hoover administration of 1928-32.

"If you aggregated all that noise, the first year is not great," he said.

But he believes that there are two big problems with forming an investment strategy based on this observation.

For one thing, the sample base is too small: There are just 21 presidential cycles over the past 84 years.

And for another, it ignores other influences on the stock market, like the health of the economy.

"If I was to tell you that the full force of the fiscal drag that we all know about - somewhere around 5 per cent of U.S. gross domestic product - hits us on Jan. 1, I don't think it matters who's in power," Mr. Zyblock said. "The market is going to struggle over the next year."

So scoff, if you want, at the Presidential Cycle. But the economic backdrop is no more encouraging.

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