You may have heard some folks claim there’s a reliable, gameable stock market pattern in presidential terms—that some years are better than others. You may have also heard that since 1926, every single year ending in “5” (1935, 1945, 1955, etc.) has been positive. Every one! But, you’ve also likely been warned these are silly indicators—as good as voodoo.
Yes, the year 5 quirk is just that—a statistical quirk. There have been eight occurrences since 1926. Since stocks rise more than fall, you’d normally expect at least two-thirds of those to be positive anyway. It’s not unreasonable that in eight coin flips, with a coin weighted to show heads two-thirds of the time, that all eight would be heads. It happens. Not all the time. But it does. But it’s still just a quirk.
On the other hand, it’s a myth and bunk that the presidential term is just voodoo—there are forceful fundamentals that can make the cycle gameable.
Table 40.1 shows presidents, their parties, and annual S&P 500 returns broken into first through fourth years of their terms. The two pages split the front and back halves of terms. Immediately you see the first two years have worse average returns with greater return variability. It’s not that years 1 and 2 are inherently bad—there can be great first and second years! There’s just more variability and some big negatives dragging down the averages. But the back half is different—average returns are much better with less return variability.
Year 3 averages 17.5 percent without a single negative since 1939, which was barely down 0.9 percent! Year 4 is fine too, with just slightly more negatives, and 2008’s big down year doesn’t help the average. Still, you get more uniformity and better average returns in year 4. Is this quirk? Or real and fundamental?

Predictable Patterns and Fundamental Drivers

Patterns happen all the time. Doesn’t mean you should make bets on them. Unless you can figure whether the pattern is rooted in sound fundamentals, and why, you should chalk it up to quirk. But there are two basic fundamental reasons behind this pattern. First, investors feel the pain of loss about twice as intensely as the pleasure of gain. We’ve been over that in Bunk 7.
Second, the word politics, as you know, derives from the Greek “poli” meaning many and “ticks” meaning small blood-sucking insects. I have no doubt that some poli-tics start as normal human beings. But within three years inside the Beltway, they will have become narcissistic little bloodsuckers with the soul of a tick. Approximately 50 percent of a poli-tic’s energy is directed at getting re-elected. The other 50 percent is directed at raising funds for said re-election campaign. This is true for congressmen (and congress-women), senators, even the president, who is Head Tic. If you know a Beltway politician who is truly a human being, you know someone I’ve never met and I’ve met hundreds over the decades.
The Head Tic knows tickiology (another comberation) very well before getting elected or he (they’ve always been “he’s” in America so far) wouldn’t get elected. So he knows his party will lose relative power to the opposition party in the mid-terms—on average 25 House and two or three Senate seats since World War II. (George W. Bush bucked the trend in 2002—one of the few ever in American history—but fell prey in 2006.) He knows that whatever his most onerous legislation (his legacy, if you will)—the toughest, most arduous, and most controversial bills—he must get them through in the first two years when he has more relative power. If he can’t get it done then, he could almost never get them through in the back half of his term when his party has less relative power. This is a form of catch-22. America is a centrist country, and the more he tries to push through in his first two years, the more relative power his party loses to the opposition in the mid-terms. This phenomenon has been true for every president.
And legislation, if passed, is nothing more than some form of redistribution of money and/or property rights (sometimes called regulation). The government takes from these rich to give to those poor, or from these rich to give to those other rich, or from these poor to those rich (if you think that doesn’t happen all the time, you’re crazy), or from these poor to those poor. Those on the losing end hate the losing more than twice as much as the winners like the winning. And because we do all this in public, those not getting mugged worry they’ll get mugged next. So, in general, political risk aversion rises when the threat of legislation increases in the first two years. The legislation doesn’t even have to pass! It’s frequently just the threat and debate that can roil stocks. As political risk aversion rises, total risk aversion rises—a negative for capital markets in general. As risk aversion goes up, overall demand for equities is decreased, hurting stocks. Increased political risk aversion isn’t enough by itself to cause a bear market, but it is a negative force on stocks.
Table 40.1 Presidential Term Anomaly—First Half More Volatile, Back Half Almost All Positive
Source: Global Financial Data, Inc., S&P 500 total return from 12/31/1925 to 12/31/2009.

Lazy Legislators Mean Happy Markets

But in the back half of a Head Tic’s term, that changes. The Head Tic’s party has already lost relative power to the opposition. He can’t get as much done and he knows it. Plus, he starts thinking about re-election himself, or helping the guy from his party get elected next to reconfirm the legacy of his presidency (or as many used to say, “We elected Ronald Reagan three times but only got him twice”).
Suddenly, politicians find lots of creative ways to yap a lot but pass little. Folks fear getting mugged less, and political risk aversion can start falling fast—helping stocks. Amazingly, we never seem to fully fathom this very real macro social phenomenon that is embedded into our political culture.
You can see in history that landmark legislation tends to pass in the first two years. The third year is best, because in year 4, poli-tics start campaigning again, hinting at all the legislation they’ll unleash once elected, and stocks like that less. But still, they talk and don’t do much usually—because they want to avoid annoying valuable swing voters. And doing annoys—somebody. Getting elected in America, a centrist country, is predicated on getting the swing voters. Democrats don’t get there by courting liberal Democrats and Republicans don’t get there courting conservative Republicans. Swing voters are everything to politicians. The more you do, the more you annoy swing voters. That’s bad for the tics. So fourth years average worse than third years, but are still overall fine and overwhelmingly positive.
Note too you must never look at just the averages, but what comprises them. Yes, first and second years have poorer average returns. But years that aren’t negative can be up huge! It’s the same fundamental force at work. Legislative risk aversion is typically highest in the first two years, but if that lessens for some reason, that can be a massive positive surprise and boost stocks.
Keep in mind, too, there are myriad factors acting on stocks. Political risk aversion is a powerful force, but just one big one, and other forces can swamp US political silliness. (Plus, though big, the US economy is less than 25 percent of the whole world,1 and global stocks tend to be positively correlated. But it’s important to note there also hasn’t been a negative third year of a president’s term since 1939 when looking at the global stock market.) For example, 2009 was President Obama’s first year and stocks were up huge, tied to a massive global rally following a steep bear market bottom. That was a huge force driving stocks. But tied to that, Democrats newly elected tend to have great first years, which bucks the average but is consistent with what makes up the average. Always dig deeper into the averages. (And read more on this in Bunk 41.) And remember, sometimes seeming voodoo isn’t bunk at all.
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