Last Updated on November 5, 2022 by Oddmund Groette
In the United States, a presidential election is held every four years. Those presidential elections have been observed to affect many government sectors, including legislation, international relations, and even the stock market. This occurrence inspired the concept of presidential election cycles. But what exactly are they?
The presidential election cycle theory is a stock market performance theory that asserts, based on historical data, that the stock market’s performance in the first two years of a U.S. president’s term will likely outperform the stock market’s performance in the last two years of a U.S. president’s term. Furthermore, midterm election years show poor performance up until the 4th quarter.
The Presidential Cycle – backtest end empirical results
Before we go on to explain the Presidential Cycle in detail, we jump straight to the backtest. Because there already exists a lot of work on the subject we refer to previous work instead of doing our own.
Yale Hirsch was, to our knowledge, the first to quantify the effect of the Presidential Cycle and its effect on stocks. In the Stock Trader’s Almanac 2020, the 53rd edition of this great book, they updated their findings. We quote from the book:
Presidential incumbency is a powerful phenomenon and the driving force behind the 4-Year Presidential Election Cycle. This quadrennial quadrille is what has made the Pre-Election Year the best year of the cycle and Election Year second best. Since 1952 S&P 500 is up 12.5% on average in election years when a sitting president is running for reelection vs. 6.7% in all election years and –1.5% in election years with an open field and no incumbent commander-in-chief running for a second term.
Mid-term election years and stock market returns
Stock Trader’s Almanac also writes that the midterm election year shows that the second year has generally been the weakest in a president’s term (2022 is such a year, 2018 as well – the two last ). That is, up until the 4th quarter which has seen the best performance in the presidential cycle:
Because the markets tend to be weak in the midterm elections, volatility picks up:
Volatility normally picks up in bear markets because the world looks more fragile. You can read more about this in our anatomy of a bear market.
What is the Presidential Cycle?
Based on historical data, it has been observed that the stock market’s performance in the first two years of a U.S. president’s term is likely to be better than its performance in the last two years of a U.S. president’s term.
Yale Hirsch, the founder of Stock Trader’s Almanac, is credited with formulating the presidential cycle theory. Hirsch found that equity market returns follow a predictable pattern when a new president is elected in the United States.
According to this idea, stock market performance in the United States is poorest in the first year, then improves, peaking in the third year before dropping in the fourth and final year of the presidential term. After that, the cycle begins again with the next presidential election.
Understanding the Presidential Cycle
In 1967, Yale Hirsch, a stock market researcher, published the inaugural edition of the Stock Trader’s Almanac. They showed that the presidential election cycle, which happens every four years, is a significant indicator of stock market performance. According to their findings, the outcomes are relatively steady, regardless of the president’s political leanings in office at the time, and the year after each presidential election marks the start of a new four-year stock market cycle.
The theory indicates that the stock market performs the worst during the first two years of the cycle. This is because wars, economic downturns, and bear markets are more likely to happen in the first half of a president’s term, while bull markets are more likely to occur in the last two years. As the following election approaches, the model suggests that presidents focus on growing the economy.
Some feel this is because presidents, competing for re-election, emphasize economic stimulus during the second half of their terms. The stimulus is intended to boost the stock market, making it easier for the incumbent president to win re-election.
For example, features of the presidential cycle could be seen in the years after Richard Nixon’s election in 1968. The Dow Jones Industrial Average fell 15.2 percent in 1969, then rose 4.8 percent, 6.1 percent, and 14.6 percent the following years. Some people thought that President Nixon was to blame for the slow but the year was followed by a steady rise in stock prices over the four-year cycle because he was trying to get re-elected.
However, the theory can’t always predict market performance exactly — for example, the stock market did best in the year after the last three presidential elections — even though historical data seems to support the hypothesis.
Relationship between Presidential Elections and Stock Market Cycles
Examining historical market data for the S&P 500, dating back to the 1930s, reveals several trends over the last 90 years. Analysts have found that the stock and bond markets tend to do less well in the year before a presidential election than they do at other times of the year.
The researchers predicted that equities would increase in value by around 8.5 percent on average over a year and that share prices would climb by less than 6 percent in the year preceding a presidential election. Bond markets delivered comparable results, with returns of around 6.5 percent in the year before a presidential election, compared to their average of 7.5 percent in any given 12-month period.
Stock market performance after elections
When looking at the historical record of market movements following presidential elections, the following trends can be seen:
- Returns on the stock market tend to be slightly lower in the year following an election, while returns on bonds tend to slightly outperform. It does not appear to matter whether a political party controls the government, but control of the White House must be changed.
- Analysts found that whenever a new party was elected to power, the stock market gained 5% on average.
- When the same president was re-elected or when one party kept control of the White House, returns were slightly higher.
However, when the analysts looked at data from midterm elections (elections that happen between presidential elections), they found that the S&P 500 did better in the years after midterms than in other years. When they analyzed the facts, they came to this conclusion: the party in power in Congress, like presidential elections, is typically not a factor in predicting the success of the entire equity market.
These equity and bond market trends were remarkably consistent unless there was a major shock, such as the great recession. According to Rob Haworth, senior investment strategy director at US Bank, the rationale for this consistency is simple: uncertainty is not a friend of the market. He argues that there is more uncertainty in the United States every four years and that the statistics reflect this.
Specific stock market sectors to watch in election years
It is critical to look at the big picture when evaluating the equity and bond markets during an election year. According to Eric Freedman, a chief investment officer of the US Bank, economic instability generated by public policy typically stays within certain enterprises rather than harming the economy as a whole. “There is often no need to consider a wide range of market issues when it comes to political decisions. He adds that it tends to be more sector-specific.”
For example, the government’s healthcare policy can change depending on which party is in control, according to Hainlin. As a result, the healthcare sector tends to exhibit increased volatility in the weeks and months preceding a presidential election. Since legislators are the key drivers of policy, any new president’s healthcare program will only have a chance of passing if members of the same party can pass legislation in Congress.
Similarly, Hainlin observes that the energy industry is frequently more volatile due to the two parties’ divergent regulatory attitudes toward domestic energy production and the desire to create incentives for new “green” energy sources. This is due to a desire to reduce greenhouse gas emissions while increasing the use of renewable energy sources.
Hainlin, on the other hand, contends that the outcome of elections has a more significant impact on the economy and commerce than any other policy problem. He claims that it is more than just a matter of who lives in the White House. Because the approval of new trade treaties is contingent on the legislative branch, it is possible that, as with other pieces of legislation, it will be determined by which party controls Congress.
Hainlin also believes that after an election is over, it is necessary to analyze the situation again to see how the policies supported by the newly elected officials might affect the global economy.
How to structure your portfolio to weather election years and the post-election period
It is prudent to keep an eye on the industries most likely to be affected by the presidential election outcome, such as healthcare.
However, there is no reason to be concerned about market volatility during the election season or after the elections. Even without the impact of elections, higher volatility has become more integrated into the investing landscape. This may not necessarily herald bad news, especially when the economy is generally solid. As Hainlin puts it, “More volatility has become a permanent part of the financial system.”
Although the drama surrounding presidential elections might make your imagination run wild, the essential thing to watch is how different policies will impact domestic and global economies. The greatest rule of thumb may be to stay invested and ensure that your portfolio is rebalanced. Even though knowing volatility and performance trends in election years may give a few investing possibilities, this is not always the case.
President election cycles – final thoughts
Backtests reveal that the Presidential Cycles have an impact on the stock market. That is rational because both federal spending and the business climate depend on the policies from Washington. All in all, we believe the Presidential Cycles is a strong seasonal pattern that needs to be looked upon if you are a market timer or if you are dollar-cost averaging.