With the midterm elections behind us and 2011 looming large, Wall Street strategists are looking forward to the famously profitable third year of the four-year presidential cycle where the best stock picks rally. The logic is easy: presidents tend to be tough in the first two years, but in the final two, with their re-elections looming, policy turns toward stimulating the economy and securing a second term.
Merrill Lynch’s chief market technician Mary Ann Bartels points out that the third year of presidential terms typically delivers a return of about 15%. Jeffrey Hirsh of the Stock Trader’s Almanac notes that there hasn’t been a down year in the third year of a presidential term since 1939, when the Dow fell 2.9%. The only severe loss going back 100 years happened in 1931, during the early years of the Depression.
We’re in the midst of the sweet spot right now — between the fourth quarter of the midterm year and the first quarter of the pre-election year. Over this period the S&P 500 has averaged a 15% gain while the Nasdaq averages a 24 rise%. This explains why, given extreme overconfidence and massively bullish investor sentiment, stocks keep grinding higher.
President Obama seems particularly aware of his need to bolster his political fortunes. He compromised with newly empowered Republicans to secure a very generous and simulative tax cut package that went beyond what most political observers believed was possible. Add to that the Federal Reserve’s new $600 billion money-printing operation, and the fact that the economy is showing signs of strengthening again after the mid-summer slowdown caused by the eurozone crisis, and the stage is set for a rip-roaring, stimulus-fueled economy burst in 2011.
The chart above, which comes courtesy of Arthur Hill at StockCharts.com, illustrates this phenomenon since 1980. The green lines mark the midterm for each president and the start of the bullish phase of the presidential term. As you can see, the bulk of the gains of the third year are concentrated in the early part of the year.
That’s something that Tom McClellan of the McClellan Market Report is looking for in early 2011. His cycle work shows only a slight hint of a minor market dip due on Jan. 16 before stocks charge higher through May. Traditionally, the November-to-May timeframe is one of seasonal strength for stock prices, so the combination of this and the third-year presidential cycle should be impressive. The autumn of the third year can see problems for stocks, such as the October 1987 market crash. But that’s over the horizon.
The takeaway here is that any market pullback over the next few weeks should be bought into, not sold into. In other words, don’t use it as an excuse to add new short positions. The risk is just too high that the market will bolt higher as positive seasonal forces, government largesse, and ultra-loose monetary policy support equity prices.
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