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Presidential Election Cycle Theory

Presidential Election Cycle Theory

What Is the Presidential Election Cycle Theory?

The Presidential Election Cycle Theory, developed by Stock Trader’s Almanac founder Yale Hirsch, contends that U.S. stock markets are weakest in the year following the election of a new president. According to this theory, after the first year, the market improves, peaking in the third year. Market returns then fall in the fourth year of the presidential term, after which point the cycle begins again with the next presidential election.

Understanding the Presidential Election Cycle Theory

Stock market researcher Yale Hirsch published the first edition of the Stock Trader’s Almanac in 1967. The guidebook became a popular tool for day traders and fund managers hoping to maximize their returns by timing the market. The almanac introduced a number of influential theories, including the “Santa Claus Rally” in December and the “Best Six Months” hypothesis, which proposed that stock prices have a tendency to dip during the summer and fall.

Hirsch’s aphorisms also included the belief that the four-year presidential election cycle was a key indicator of stock market performance. Using data going back several decades, the Wall Street historian posited that the first year or two of a presidential term coincided with the weakest stock performance. According to Hirsch’s philosophy, after entering the Oval Office, the chief executive has a tendency to work on their most deeply held policy proposals and indulge the special interests who have gotten them elected.

As the next election looms, however, the model suggests that presidents focus on shoring up the economy in order to get re-elected. As a result, the major stock market indices are more likely to gain in value. According to the theory, the results are fairly consistent, regardless of the president’s political leanings.

Historical Market Performance and the Theory

A vast number of factors can impact the performance of the stock market in a given year, some of which have nothing to do with the president or Congress. However, data over the past several decades suggest that there may in fact be a tendency for share prices to increase as the leader of the executive branch gets closer to another election.

In 2016, Charles Schwab analyzed market data going back to 1950 and found that, in general, the third year of the presidency overlapped with the strongest market gains. The S&P 500, a fairly broad index of stocks, exhibited the following average returns in each year of the presidential cycle:

  • Year after the election: +6.5%
  • Second year: +7.0%
  • Third year: +16.4%
  • Fourth year: +6.6%

Since 1950, the average annual rate of return for the S&P 500 has 10.82%. So while the numbers don’t show a sizable dip in years one and two, as Hirsch predicted, it appears there truly is a third-year bump.

However, averages alone don’t tell whether a theory has merit; it’s also a question of how reliable it is from one election cycle to another. Between 1950 and 2019, the stock market experienced gains in 73% of calendar years. But during year three of the presidential election cycle, the S&P 500 saw an annual increase 88% of the time, demonstrating a notable consistency. By comparison, the market gained 56% of the time and 64% of the time during years one and two of the presidency.

Donald Trump’s tenure has been a notable exception to the first-year stock slump that the theory predicts. The Republican actively pursued an individual and business income tax break that was passed in late 2017, fueling a rally that saw the S&P 500 rise 19.4%. His second year in office saw the index take a 6.2% dive.

But once again, the third year marked an especially strong time for equities, as the S&P surged 28.9%.

Over the past 60-plus years, the third year of the presidency saw an average stock market gain of more than 16%. But the limited number of election cycles makes it difficult to draw reliable conclusions about the theory.

Special Considerations

Overall, the predictive power of the presidential election cycle theory has been mixed. While average market returns in years one and two have been slightly sluggish overall, as Hirsch suggested, the direction of stock prices hasn’t been consistent from one cycle to the next.

The bullish trend in year three has proven more reliable, with average gains far exceeding those of other years. What’s more, roughly 90% of all cycles since 1950 experienced a market gain in the year after the mid-term elections.

Whether investors can feel comfortable timing the market based on Hirsch’s supposition remains questionable. Because presidential elections only occur once every four years in the United States, there’s simply not a large data sample from which to draw conclusions. The reality is that there have only been 17 elections since 1950.

And even if two variables are correlated—in this case, the election cycle and market performance—it does not mean that there’s causation. It could be that markets tend to surge in the third year of a presidency, but not because of any re-prioritizing by the White House team.

The theory also rests on an outsized estimation of presidential power. In any given year, the equities market may be influenced by any number of factors that have little or nothing to do with the top executive. Presidential sway over the economy is also limited by its increasingly global nature. Political events or natural disasters, even on other continents, could affect markets in the United States. As, of course, can a global pandemic.

In a 2019 interview with The Wall Street Journal, Jeffrey Hirsch, son of the Presidential Election Cycle Theory’s architect and the current editor of the Stock Trader’s Almanac, indicated that the model still holds merit, especially when it comes to the third year of the term. “You have a president campaigning from the bully pulpit, pushing to stay in office, and that tends to drive the market up,” he told the newspaper.

However, in the same interview, Hirsch acknowledged the theory is also susceptible to unique events in a given cycle that can influence the mood of investors. He noted that the makeup of the Senate and House of Representatives, for example, can also be an important determinant of market movements. “You don’t want to jump to conclusions when there aren’t many data points,” he told the Journal.

<Source: Investopedia>

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