The Presidential Election Cycle and Investing
Does the Presidential Election Cycle predict what the stock market will do? History reveals there is some relevance to this stock market indicator, but investors should be cautious in basing their investment strategies on the outcome of a presidential election.
Here's what to know about investing and U.S. presidential elections:
Presidential Election Cycle Definition & How It Works
The Presidential Election Cycle is a theory first developed by a stock market historian named Yale Hirsch. The theory evolved to be used as a market timing indicator for stock investors.
Here are the fundamental assumptions, in relation to stock market performance, for each of the four years of a US President:
- In years one and two of a presidential term, the President exits campaign mode and works hard to fulfill campaign promises before the next election begins. For this reason, the first year is typically the weakest of the presidential term and the second year is not much stronger than the first.
- This trend of relative weakness is because campaign promises in the first half of the presidency are not typically aimed at strengthening the economy; they are aimed at political interests, such as tax law changes and social welfare issues.
- In years three and four of the Presidential term, the President re-enters campaign mode and works hard to strengthen the economy. For this reason, the third year is typically the strongest of the four and the fourth year is the second-strongest of the four.
- The second half of the presidency is usually stronger than the first because of economic stimuli, such as tax cuts and job creation.
History and Accuracy
To summarize the stock market performance aspect of the Presidential Election Cycle Theory, the performance of stocks, ranked from the best year to the worst, is the third year, the fourth year, second year and first year.
As with any market timing strategy, the overall pattern of investment performance related to the Presidential Election Cycle may be convincing, but the pattern is based on averages and averages do not guarantee consistent results!
For example, stock market performance in the first two years of Barack Obama's first presidential term was much stronger than his third year. And the same results occurred in Obama's second term — the first two years were much stronger than the third and fourth. Also, George H.W. Bush's first year was much stronger than his third and fourth, and Bill Clinton had strong first years in both of his terms.
A wise investor will consider the Presidential Election Cycle as only one of many factors influencing economic and market conditions. Certainly, politics do play a role in financial markets and the legislation passed in Congress (often originating from a sitting President's legislative agenda) does have a significant impact on corporate earnings. However, the timing of any given year of a sitting President's term is just one-factor influencing market risk, which can include world economic conditions, interest rates, investor psychology, and weather.
Can It Influence the Stock Market?
The overriding caution with using any timing strategy is that the strategy is not ever reliable enough to remove market risk, which exists primarily due to the random and unforeseeable nature of economic and market conditions. It is a classic example of the folly of confusing causation with correlation — some of the overall stock market returns are attributable to political activities, but much of the relationship between the President's actions (or inaction) is coincidental. In fact, there have been correlations found between the winner of the Super Bowl and stock market performance.
Can a football team influence the stock market? Perhaps not as much as a US President but you get the idea: Don't bet the farm on a pattern. At the same time, a prudent investor wouldn't bet against remarkable patterns either.
While history does show that the third year of a President's term has been, on average, better for stocks than the first year of the presidency, the key phrase is "on average." There is never any promise that every presidential term is "average." Furthermore, the President of the United States does not have enough power to control the global political environment.
Similarly, investors have no means of controlling the investment returns of their stock mutual funds on a year-to-year basis. The greatest determinant of a mutual fund portfolio's return is asset allocation and the types of funds used, not the year of a President's term.