LONDON, 22 September 2003 — With just 13 months to go until presidential elections, effects of a phenomenon popular as the political business cycle (or presidential business cycle) should be incorporated in your medium-term investment strategy. This is particularly true when considering that the market’s recent rally perfectly fits in the decade old pattern of strong market showings in the year leading up to US presidential elections. These rallies are often attributed to attempts by the administration to manipulate the economy to achieve personal political goals - primarily to remain in office.
Let us be careful not to get lost in any wild conspiracy theories. No modern day president has absolute control over events. However, the current all-out fiscal and monetary stimulus by the government epitomizes traditional economic policy before an election. These measures usually create a business cycle expansion that ensures (as is hoped by the respective administration) their re-election.
Monetary and fiscal policies pursued excessively have politically popular consequences in the short run. People’s tax burden is reduced, unemployment falls, interest rates are low, and many special interest groups profit from new government spending.
The trade-offs are unpleasant consequences in the longer term. This can be in the form of accelerating inflation, unsustainably low rates of savings to support future investment, damage to the foreign trade balance, or long term expansion of government’s share of the GNP at the expense of people’s disposable incomes. Immediately following elections, administrations thus tend to reverse course by raising taxes, cutting spending, slowing the growth of the money supply, allowing interest rates to rise, etc. Nevertheless, elections exacerbate the natural boom and bust pattern in the economy.
Stock markets tend to anticipate the economic development described above. They exhibit a similar pattern as the underlying economic development. However, capital market theory suggests that anomalies (patterns) that allow an investor to repeatedly realize profits are quickly eliminated after being discovered by the market. In that respect, equity markets tracking the presidential cycle seem to be an exception.
Although a well-known phenomenon, it is one of the most persistent patterns in the stock markets. Let us look at the last 30 years. Stock markets bottomed out in 1974, ’78, ’82, ’90, ’94, ’98, ’02 (1986 is missing because its bottom occurred one year later) Without fail stock markets were rising in the subsequent two years toward election. Astonishingly, the last market decline in the third year of the political cycle was in 1939 — ancient history in financial and economic terms.
Some allege the presidential election cycle would never occur with tax cuts and governmental transfer payments alone. They see in the ostensible autonomous Federal Reserve System a major contributor to the cycle. It is argued that with elections approaching, governments eager to please voters do not refrain from putting heavy political pressure on all financial authorities - even if they were intended as legally independent bodies. Obviously, political clout is never fully avoidable.
No clear pattern of politically motivated fed fund target rate changes is discernible. How heavily the present administration lobbied today’s extremely aggressive monetary policy is a separate issue. The first half of the cycle’s third year is usually better than the second half. From 1947 through 1999 the S&P500 gained an average of 13.3 percent in the first six months of year three and 4 percent in the last six months. Having experienced a very strong stock market rally form March to mid June, we are currently trading flat.
For the rest of the year we expect markets to behave in accordance with previous elections. Although much more moderate than in the first half, stocks will achieve additional gains in 2003. Of course history seldom repeats itself exactly. However, with the current economic catalysts in place, it is a lot to bet against.
(The information contained herein is for information only and should not be construed as an offer or a solicitation to purchase, subscribe, sell or redeem any investments. While Clariden Bank uses reasonable efforts to obtain information from sources, which it believes to be reliable, Clariden Bank makes no representation or warranty as to the accuracy, reliability or completeness of the information).
