What is the Presidential Cycle?
The Presidential Cycle is a theory that suggests that the United States stock market experiences a decline in the first year that a new president takes office. The theory was first developed by Yale Hirsch, a stock market historian. It suggests that the US presidential elections exert a predictable effect on the economy. Specifically, the stock market starts to improve in the second year after the election, and the cycle continues in the next presidential election.
Hirsch’s theory was “effective” in the 1900s, and investors even used the presidential cycle as a market timing indicator for the stock market. However it has since lost its predictive power and had various presidents take office and actually see a surge in the stock market, namely the S&P 500 rose in the first years of the Trump, Bush and Obama Administration.
Reasoning behind the Presidential Cycle
Here is some of the proposed reasoning as to why the election of a new presidents affects the stock market performance.
When the president is elected, he/she has to work towards fulfilling his/hers elections promises. These often include policies that will have a negative effect in the short-term however, they could have been popular during the election and helped the president get elected. Typically the first two years of a presidential term are the weakest, due to the implementation of these various policies.
In the third and fourth year, the stock market would do well again, as there is a chance of re-election the sitting president will start campaigning again, and having a strong economy is a great way to get votes. The president will prioritize programs that aim to heat up the economy, making the third and fourth years the strongest of his four-year term.
Is the Presidential Cycle Accurate?
Past history of the stock market’s performance during US presidential elections shows that there is some relevance in the using the presidential cycle as a stock market indicator. Since the presidential election cycle has been proven false in the late 20th century and the early 21st century, investors should only use the cycle as one of the factors, rather than as the only factor, that influences the economic and market conditions.
The lack of evidence to support the presidential cycle suggests that it is not an effective strategy to try and benefit in the stock market. There are both systematic risk and idiosyncratic risk in the market that go way beyond a presidential election.
In addition, the US president lacks the power to control what happens in the global political environment. Certainly, political actions by the president and legislation originating from the US leader or the legislators from his party still affect the financial markets.
However, the timing of the president’s term regarding the stock market is one of the factors influencing market risk, and other factors may include the investor psychology, interest rates, and the performance of the global economy.
Case Study: Performance of the S&P 500 during Presidential Election Cycles
The Schwab Center for Financial Research analyzed the S&P 500 market performance from 1950 to 2015 to determine how the market performance correlated with the presidential cycles. The study looked at 16 election cycles, in which the first year of the cycle coincides with the first year of the US president’s term. It revealed that, in the first year, nine of the 16 cycles analyzed finished lower than the rest of the years in a president’s term.
The third year of the cycle was the best year for equities, rising in all but two of the 16 cycles analyzed, and with an average return of 16.4%. The last year of the cycle, which is also the actual election year, was found to have been good for equities, and it rose in 81% of the cycles analyzed and delivered an average return of 6.6%.
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