YEAR 3 OF PRESIDENTIAL CYCLE: IS THIS TIME DIFFERENT?

Many pundits are writing about the highly favorable odds of rising equity markets during the 3rd year of the Presidential Cycle. This chart from Jeremy Grantham’s GMO tells you to close your eyes, pinch your nose and jump deep into equities.

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Not investing in the US? Read on!

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Grantham adds:

Also, to repeat a favorite statistic, the record says that 19 Year 3s have occurred since FDR with not one serious bear market – in fact, just one Year 3 was down, finishing at -2%. Who wants to bet on the 20th being different this time?

Gridlock, you say? RBC Capital Markets shows that this is not a problem:

Gridlock is the odds-on favorite with only a few days left to go before the November 2nd mid-term elections.
The Senate race is nearly a dead heat, with Intrade.com handicapping the odds of Democratic victory at 56%. In
contrast, this prediction market has assigned an 89% chance to a Republican victory in the House. Our market
economics team recently reported that gridlock has been associated with a better economic outcome. What can we say about the equity market?

We have looked at how the equity market has performed in the 50, 100 and 200 days following the results of all
mid-term elections since 1942. What really pop out to us are the strong returns following the election outcome regardless of the holding period. At the same time, the odds of a negative return appear relatively rare (e.g., 50 days after the election) to non-existent (e.g., in the 200 days after the election). As we dug into the details, we also found a slight performance edge generated in periods following gridlock.

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One might want to add that equity markets look particularly cheap currently, that earnings keep surprising most everybody on the upside and that the FED is about to inundate us with even more liquidity and bring interest rates even lower!

Not that I want to ruin the party and stop you from rushing out and call your friendly broker, but maybe some consideration should be given to the current “highly unusual uncertainty” facing the economy and the many highly sensitive politico-economic decisions that need to be made to get the US out of its most severe economic distress since the Great Depression. Gridlock just does not strike me positively here!

Jeremy Grantham also thinks that there are arguments for “this time is different”:

This year, a Year 3 has been preceded by two abnormally stimulated years when, typically, the Fed works to cool the markets down in Years 1 and 2. This time, Years 1 and 2 were turned into a sort of massive Year 3 in which low rates and moral hazard added to the market’s natural reflex to have a big rally after a major nerve-rattling decline. The market responded by rallying 82% in 13 months (to April 26, 2010), with risky stocks up by over 120%, both second only to the rally from the low of 1932.

Also unique this time is the great bust of 2008 and the ensuing great bailout. How much difference do you want?

Even so, I expect that the bottom line will come down to short rates. Surely they will stay low for the entire Year 3. And, if so, the “line of least resistance” is for the market to go up and for risk to flourish. In the last six months I’ve guessed on separate occasions that levels of 1400 or 1500 on the S&P 500 are reachable a year from now; this still seems a 50/50 bet. If we include more moderate market advantages, the total odds would be well over 50%.

Risks to this forecast are highlighted by some ugly near-term possibilities. The worst of these is that Senator Smoot and Representative Hawley, sponsors of the anti-trade bill of 1930, will pull a Night of the Living Dead and prepare a very dangerous opening salvo in the next global trade war. Indeed, today it feels as if there were an inexhaustible supply of politicians who would put their political/ philosophical principles way ahead of global well being. As mentioned earlier, the Fed is also stirring up a hornet’s nest on the currency side of this issue with its quantitative easing. There is also the definite possibility that we could slide back into a double dip, so we may get lucky and have a chance to buy cheaper stocks. But probably not yet. And, of course, if we get up to 1400 or 1500 on the S&P, we once again face the consequences of a badly overpriced market and overextended risk taking with six of my predicted seven lean years still ahead. And this time the government’s piggy-bank is empty. It is not a pleasant prospect.

Now who is the real party killer here?

 

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