Stock markets could be set for a correction this year if previous cycles related to US presidential elections are anything to go by.
By law, presidential elections are held every fourth year in November. We are now in year two of the current four-year cycle. The predictable length of these election cycles appears to have triggered several stock market trends worth thinking about.
Years three and four of a US presidential term are traditionally good for investors. The UK stock market rose 11 times in a row in the third year of a cycle during the last four decades. Prices increased during year four in 10 of the last 11 election cycles.
A much weaker trend often emerges near the beginning of the election cycle. UK prices rose just 25 per cent of the time in the last few decades during the first year of a new presidential term and 44 per cent of the time in year two.
Statistics such as these help to explain why bear markets appear so often in the second year of a presidential cycle. Since 1961, there were 11 presidential cycles. The UK market suffered a downturn that hit prices by at least 20 per cent in seven of those years. Corrections in the 16 per cent to 18 per cent range occurred in two other years. In some of those cases, the downturn began in year one of the cycle. But every one of them bottomed out in year two.
There is nothing random or coincidental about these bouts of year two weakness. Presidents are like other politicians: they like to win elections. It is standard for their team to attempt to create positive economic conditions around election day when voters go to the ballot box. In economies as large and complex as America’s, action must be taken well in advance to achieve a desired effect at a desired time.
The forward looking stock market typically reacts in advance to these economic stimulants in years three and four. Unfortunately, boosting the economy with tax cuts, low interest rates or excessive spending often creates knock-on effects. Economic problems are sometimes created. These chickens often come home to roost a few years later. It helps to explain why the stock market often disappoints investors near the start of a new cycle.
A similar pattern of year two weakness exists in the US. There were five consecutive cycles in the 1960s and 1970s when stock markets were down in the second year of presidential terms. Although Wall Street is widely thought to have risen in the 1980s and 1990s, we saw a 16 per cent dip in 1982 (although the S&P 500 ended the year up overall) and further red ink in 1990 and 1994. The tech bubble began in 1998. But who can forget the sudden dip from mid-July to early-October that hit shares by 19 per cent?
The most recent second year in the cycle occurred in 2002, the bottom of the worst bear market in three decades. A cursory review of all the statistical evidence reveals that 1986 was the only mid-cycle year that suffered no significant dip in the US since 1958.
So what lies ahead for 2006? History hints that it might soon be time for UK investors to don their safety belts. A good clue is linked to the size of the gain that the FTSE All Share index produced in November and December in 2005. Big gains such as the one a few months ago are a worrying sign.
There were seven occasions since 1954 when the stock market rose strongly in the final two months of year one of a presidential cycle. Shares peaked in year two no later than May in all but one of those years. On the other hand, shares either rose weakly or fell in November and December of year one in seven other presidential cycles. Prices reached their high water mark much later in year two on six of those occasions.
The statistical link between powerful late year one rallies and early year two peaks is quite robust. Given that shares rose by 7 per cent in November and December 2005, history warns that prospects for the rest of 2006 are worrying.
David Schwartz is a stock market historian
