Monday, November 3, 2014

Year 3 of The Presidential Cycle Is Unlikely To Go The Way Everyone Expects

If you even passively follow equity markets, chances are high you have already read a number of articles about "Year 3 of the Presidential Cycle". That period is starting right now, and it's incredibly bullish. In the chart below, we are entering the steep ascent where the SPX has risen 22% in a year on average (since 1950).

If you are wondering why equities rallied 10% in the past two weeks, this is a better reason than most. In the past 60 years, Year 3 has never provided a negative return. With elections tomorrow, now is apparently the time to get long.

There's just one thing: why would this set up work? The stock market is not known for giving investors an easy return with a 100% probability for success. Curiously, we have yet to see any analyst question the premise of this set up.

Let's dig in.

The first thing you should notice in the chart above is the period to the left leading into Year 3. Year 1 and Year 2 returns are modest. Quarterly returns swing positive and negative. It looks like a period where investors are being shaken out. That should correspond to the 4th quarter of 2012, all of 2013 and so far in 2014. Is that what has happened?

The answer is no. Since mid-2012, SPX is up 60%. It rose 30% in 2013 alone, about 4 times greater than the average Year 1. On a quarterly basis, the chart below shows how SPX has traded relative to the typical pattern in Year 1 and Year 2. Instead of declining in 1Q13, SPX rose 10%. In 4Q13, it rose another 10% instead of the 3% which is normal. In 2Q14, SPX rose 5% instead of falling 3%. It doesn't match the seasonal pattern leading into Year 3 at all.

If Year 1 and Year 2 are supposed to shake out investors to set up a booming Year 3, it has failed this time. SPX has been up 7 quarters in a row. The last time this happened was 16 years ago during the height of the tech bubble (1998). The only other time it was up even 6 quarters in a row was 50 years ago (1965).

Which brings up a basic point about why Year 3 is usually bullish. The presidential party wants to remain in office. To the extent the ruling party in the executive and legislative branches can influence the economy (sometimes more, sometime less), they will pursue whatever hard economic policy agenda in Year 1 and 2 in order to be on firm footing by Year 3. This doesn't always work, but it does happen a surprisingly high percentage of the time.

If nothing else, take away from this post that major bear markets, corrections of 20% or more and/or recessions have ended right before many Year 3s. In fact, this has been the case in 18 of the past 21 cycles (86%).

In the past 21 cycles, there have been 14 recessions that ended just before or during Year 3. There have been 14 major bear markets ending just before or during Year 3. If there wasn't a full fledged bear market, there was often a long correction of 20%. This is the single most significant feature explaining why Year 3 has been so bullish: the period leading into Year 3 has been decidedly bearish.

This leaves just 3 exceptions: 1986, 1994 and 2006. You would never draw a conclusion that Year 3 is bullish based on a sample of only 3. Even here, the set up was different than it is today.

2013 was up 30%; in comparison, 1994 was down 2% for the year and 2005 was up a scant 3%.

Heading into the 1994 election, SPX had been dead flat the prior 20 months. Heading into the 2006 election, SPX had a 3 month shakedown that knocked the Investors Intelligence bull:bear ratio to just 1.0x.  That also happened in 1986; by October 1986, the bull:bear ratio was just 0.8x after a 3 month drawdown of 10%. In comparison, that ratio has been over 3.0x for most of the past 12 months, the longest stretch in 25 years.

So, Year 1 and 2 are vastly different this time than it has been when Year 3 has produced those 22% returns. And there hasn't been a multi-month shakedown to reduce bullishness either.  In fact, SPX just had one of the strongest two week rallies seen in the past 75 years. Investors are aggressively bullish.

Let's assume the script still works for the next several quarters. Using the second chart above (with the blue bars), SPX would rise to 2130 by the end of 2014, then to 2300 by 1Q15 and 2410 by 2Q15. Meanwhile SPX sales are growing at 3.7% and the consensus estimate (which is usually too optimistic) expects that to continue in 2015. By year end 2014, price/sales would be 1.8x; by June 2015, price/sales would be 2.0x. That is higher than at the peak of the tech bubble (chart by Yardeni).

The Dow has never risen over 5% each year for more 5 years in a row. Since 1900, these streaks have tended to last 3-4 years. It lasted 5 years in the mid-90s and the current streak is also 5 years. If the script for Year 3 works, the Dow will be up 11% this year, making the streak 6 years. A 20% gain next year extends the streak to 7 years. This would be unprecedented.

In summary, the set up that has existed for 86% of Year 3s is missing. Arguably, the set up for 100% of Year 3s is missing. And if Year 3 follows the script, valuations would be higher than at the top of the tech bubble and the Dow would have blown away even its impressive winning streak from the 1990s. Count us as being skeptical.

To be clear, this doesn't mean that US equities are set to fall or that 2015 won't be another positive year. But the hockey stick returns a hundred articles have led investors to believe are a sure thing in the coming Year 3 seems improbable. It's likely to be a trickier year than almost anyone now expects.

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