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Wednesday, September 24, 2008

Analyzing The Presidential Election Cycle

Analyzing The Presidential Election Cycle By Zhuge Liang

Think who you vote for for president will affect the economy? According to the Presidential Election cycle theory, it may not make a
difference. History suggests that the stock market and the four-year presidential election cycle follow strong, predictable patterns. So, whether you're voting Democrat, Republican or just staying home, find out what these patterns can tell you about the stock market - and perhaps even the next presidential race.

What Is the Presidential Election Cycle Theory?
The presidential election cycle theory, which was developed by Yale Hirsch, is based on historical observations that the stock market follows, on average, a four-year pattern that corresponds to the four-year election cycle. The theory suggests that on average, the stock market has performed in the following manner in each of the four year that a president is in office:

Year 1: The Post-Election Year
The first year of a presidency is characterized by relatively weak performance in the stock market. Of the four years in a presidential cycle, the first-year performance of the stock market, on average, is the worst.

Year 2: The Midterm Election Year
The second year, although better than the first, is also is noted for below-average performance. Bear market bottoms occur in the second year more often than in any other year. The "Stock Traders Almanac" (2005), by Jeffrey A. and Yale Hirsch, Hirsch notes that "wars, recessions and bear markets tend to start or occur in the first half of the term."

Year 3: The Pre-Presidential Election Year
The third year or the year preceding the election year is the strongest on average of the four years.

Year 4: The Election Year
In the fourth year of the presidential term and the election year, the stock market's performance tends to be above average.

Can Stock Markets Pick Presidents?
Most studies on the presidential election cycle look at the relationship the presidential cycle has on stock prices. However, rather than the election cycle predicting a trend in stock prices, maybe the trend in the stock market can predict who will be elected president.

In a study done by John Nofsinger, "The Stock Market and Political Cycles", which was published in The Journal of Socio-Economics in 2007, Nofsinger proposed that the stock market can predict which candidate will be elected. He analyzed the relationship between the social mood of the country and the presidential election and concluded that when the country is optimistic about the future, the stock market tends to be high and voters are more likely to vote for those in power. When the social mood is pessimistic, the market is low and people tend to vote out the incumbent and put a new party in power. According to Nofsinger's research, the stock market returns in the three years prior to the election is useful in predicting whether the incumbent party candidate will be elected or whether there will be a new party in power at the White House.

Market Bottoms and the Presidential Cycle
Stock market cycles are well documented, with alternating bear and bull markets. When those cycles are superimposed over the election cycle, it is found that market bottoms tend to occur in the first term of a presidency.

In his study "Presidential Election and Stock Market Cycles," Marshall Nickels of Pepperdine University analyzed stock market bottoms in relation to the presidential cycle. In the period from 1942 to 2006, there were 16 presidential terms and 16 market lows corresponding to those terms.

Three of the lows occurred in the first year of the presidential term, 12 in year two, one in year three and none in year four. Of the 16 bottoms, 15 occurred in the first half of the term and only one in the second half of the term.

Monetary Policy and the Presidential Election Cycle
The Federal Reserve sets the monetary policy for the country. Although the Federal Reserve is supposed to be independent of the president and the Congress, monetary policy appears to follow the presidential election cycle as well.

In a paper entitled "The Presidential Term: Is the Third Year a Charm", prepared by the CFA Institute and published in the Journal of Portfolio Management in 2007, the authors found that monetary policy is more accommodative in the second half of a presidential term and more restrictive in the first term. These findings suggest that policy makers are reluctant to take a restrictive stance for fear it might slow down the economy in the months leading up to a presidential election. Of the four years, the third year is the year with the most expansionary monetary policy. During that year, the author found that monetary policy was expansionary 65% of the time versus 48% for the other three years.

Stock markets do well in periods of expansionary monetary policy and do relatively poorly when monetary policy is restrictive; therefore, it is no coincident that the stock market is generally strong in the third year of a presidential cycle, when the Federal Reserve is in an expansionary mood.

Conclusion
Although the relationship between the presidential election cycle and the stock market appears to be strong, this does not mean it is going to play out the same way every cycle. However, when combined with other information, it can provide additional insights that investors can use to improve their investment decisions

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