It was a frustrating time to manage bond portfolios as there were barely any assets to buy that I felt compensated me for the risk taken. Fortunately, my firm avoided, for the most part, the nasty spread widening in risky instruments of late—a widening that I feel is far from over.

20-year Timeline of the VIX Index

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The Impact of the Presidential Cycle on the Markets

Investors and analysts like to talk about the presidential cycle and its impact on the stock market. To be sure, there is a tendency for markets to bottom in the early part of a presidential term only to rally in the last two years of the cycle as fiscal and monetary stimulus are applied to the economy. The Pepperdine University Study I highlighted in last week’s piece has some interesting findings, explained below.

Presidential Elections and Stock Market Troughs

It’s said that numbers don’t lie. So some people may just want to stay invested during the third and fourth year of a term and avoid the first two. This, in a vacuum, probably isn’t a bad idea—except for the fact that we don’t live or invest in a vacuum.

I started giving more thought to this concept lately as I can’t shake the idea that the 2009-2010 period could be unpleasant, particularly for long only, benchmark driven investors. I recently began to consider what the presidential cycle looks like when we compare how the cycles stack up in the midst of a secular bear market (we believe one started in March 2000) or in a secular bull market. Secular trends tend to last 10 to 20 years. Secular bear markets tend to bottom when the 16 year trailing return of the Dow Jones Industrial Average approaches zero, while secular bulls tend to top when the Dow has a 16 year trailing return topping 10%. Important to note is that the more excessive the 16 year trailing return, the nastier the ensuing secular bear market. You could say that there is a pattern developing here, where protracted periods of greed are followed by longer, nastier corrective phases.

Presidential Cycle and Stock Returns by Year since 1897 (secular bear years in red)

The results of the study aren't terribly surprising. Note that markets tend to do very well in election years, but not so well during election years in the midst of a secular bear market, yielding returns of barely over 4% on average. If you remove the outlier year of 1904 (markets were much more volatile 100 years ago), the average for election years in the midst of secular bear markets falls closer to zero. So it's no surprise that this year has been negative to date. Election years during secular bears tend to be the worst of all. The average return is below 4% but when one takes 1933, the first year of FDR’s term, out of the equation, results head below zero with many double-digit losing years. The same can be said for mid-term years.

When we pile up all of the years of complacency and lack of risk premium in the midst of a secular bear, one can easily make the case that the next couple of years might be tough. In fact, I'm firmly convinced that as the new president takes office it is likely that much of the stimulus (tax cuts, money growth, etc.) will be removed from the market and the unwinding of leverage may take hold.

Annualized Dow Jones Industrial Average 16 Year Cycle

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This chart shows that at the start of 2000 the market was the most overbought from a secular standpoint than at any other time in history. What follows should be a longer, nastier, secular bear, one I expect to resume in earnest after a choppy remainder of 2008. Election year jitters could likely take hold around mid-year and while not a political analyst, I would think the market would cheer a McCain win, as we would then have political gridlock, a condition that many investors find the most appealing. A Democratic win would likely shake investors as inflation tends to be much higher during times when Democrats are firmly in control. These are not partisan thoughts, just thoughts about the markets. 

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