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Presidential profits

Created:

27 May 2008

Written by:

Simon Thompson

The hard slog for Democratic candidates Hilary Clinton and Barack Obama is almost over, with the odds now heavily favouring a final race for The White House between Mr Obama and Republican nominee John McCain. We will have to wait another five months until 4 November 2008 for election day itself, and the new president won't be moving into 1,600 Pennsylvania Avenue until January. But in the meantime you can hone your equity trading strategy to maximise profits ahead of the heavyweight title fight.

We can do this because there are some extraordinary correlations between stock market cycles and presidential ones. I have uncovered no fewer than three equity trading strategies that have delivered substantial profits to investors over the past five decades with an incredible 100 per cent track record.

Pre-election and election years

It's a well-known fact that the US equity markets do well in both pre-election and election years. Since 1965, the Dow Jones Industrial Average has risen in every single pre-election year (see table one), recording an average annual profit of 17.9 per cent. And this trend has a habit of continuing into election year (see table two), when the average rise has been 8.7 per cent, with 8 up years out of the past 10.

It's also an easy relationship to explain, as it is in the interest of the incumbent administration to maximise voter approval ahead of the election. With this in mind, the executive branch of the government can time the implementation of fiscal policy - either through changes to taxation or spending plans - in order to boost the economy in the run-up to the election and make people more prosperous. This year is no exception, with the Republicans announcing a $150bn (£75.8bn) package of tax rebates in the spring, ostensibly to ease the plight of struggling consumers and homeowners.

Table 1: Performance of US Market in Third Year of US Presidential Cycles Since 1965

Table 2: Performance of US Market in Fourth Year of US Presidential Cycles Since 1965

There is also some merit in the argument that the government has an interest in trying to influence monetary policy, too, by pressurising The Federal Reserve to ease monetary conditions - through lower interest rates and increases in the money supply - to give a further boost to the economy and, in so doing, improve the feel-good factor among voters. In reality, it is debatable and very subjective how much influence the executive branch of the US administration has in influencing monetary policy.

That said, right on cue, the cuts in US interest rates from the autumn of 2007, coupled with the attempts of the Federal Reserve to boost liquidity in distressed financial markets - in response to the slowing US economy and the sub-prime mortgage crisis - is exactly the easing of monetary policy that the Republican administration would have wanted ahead of the November 2008 election.

And that raises another major issue: moral hazard. This is the understanding that the government or the central bank will bail out investors who've made mistakes, thus encouraging reckless lending or risky investments. If investors think the state is effectively standing behind them, they'll be more confident. That is logical, as the economic measures being implemented ahead of the election will also benefit companies, so this is good for corporate profits. In turn investors are more likely to aggressively buy equities in the years running up to an election, safe in the knowledge that if anything goes wrong, then the government and the Federal Reserve will come to the rescue.

Assuming the gamble by the government pays off, the story is rather different following the election. That's because the pre-election tax cuts and spending spree will have weakened the public finances and as a result the process goes into reverse, as the mini-boom fuelled by the economic stimulus starts to wane. In the circumstances, it would be rational for the US stock market to react accordingly to the economic retrenchment by performing less well in the two years following an election.

Post election blues

Whether you believe there is manipulation over fiscal and monetary policy ahead of the election, what can't be doubted is that the stock market behaves as if there is. In fact, the returns in the year after the election and the second year of the cycle are pretty appalling with the Dow Jones Industrial Average rising a pitiful 3.3 per cent and 1 per cent, respectively, since 1965 with as many down years as up years. This is in keeping with the theory that the boost to the economy in the run up to the election starts to wear off pretty quickly after the new President takes office. Investors get a serious bout of the post election blues. And this is hardly good news for the prospects of equity markets into 2009 - on both sides of the Atlantic. But before we get too gloomy over prospects for US equity markets next year, there is a potentially lucrative trading strategy to take advantage of this year.

In the next part of this feature, The presidential trading strategy, I'll explain what it is, and how it works. But to read that, you need to be an IC Advantage subscriber. Find out more about IC Advantage.

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