Do you think who you vote in for president will affect the economy? According to the presidential election cycle theory, it may not make a difference. History suggests that the stock market and the four-year presidential election cycle follow strong, predictable patterns. So, whether you're voting Democrat, Republican or just staying home, find out what these patterns can tell you about the stock market - and perhaps even the next presidential race. (For another take on how politics can affect the stock market, see For Higher Stock Returns, Vote Republican Or Democrat?)

Tutorial: Economic Indicators To Know

What Is the Presidential Election Cycle Theory?
The presidential election cycle theory, which was developed by Yale Hirsch, is based on historical observations that the stock market follows, on average, a four-year pattern that corresponds to the four-year election cycle. The theory suggests that on average, the stock market has performed in the following manner in each of the four year that a president is in office:

Year 1: The Post-Election Year
The first year of a presidency is characterized by relatively weak performance in the stock market. Of the four years in a presidential cycle, the first-year performance of the stock market, on average, is the worst.

Year 2: The Midterm Election Year
The second year, although better than the first, is also is noted for below-average performance. Bear market bottoms occur in the second year more often than in any other year. The "Stock Traders Almanac" (2005), by Jeffrey A. and Yale Hirsch, Hirsch notes that "wars, recessions and bear markets tend to start or occur in the first half of the term."

Year 3: The Pre-Presidential Election Year
The third year or the year preceding the election year is the strongest on average of the four years.

Year 4: The Election Year
In the fourth year of the presidential term and the election year, the stock market's performance tends to be above average.

Stock Market Return by U.S Presidential Term Year

Year Average Annual Return
1 7.41%
2 10.21%
3 22.34%
4 9.79%
Source: S&P 500 Total Return Index

Although the numbers will change somewhat depending on the exact time frame used, the basic pattern has persisted - a weak first half and a strong second half of the presidential term. (For more, read Analyzing Chart Patterns: Why Charts?)

Statistically Sound or Statistical "Fluke"?
One of the problems with drawing conclusions from the presidential election cycle is that the theory is based on relatively few observations. Since 1900, there have been only 27 presidential cycles to 2008. Many of the studies done on the theory are based on even fewer observations. For example, since 1948 there have been only 15 different terms - when it comes to statistics, this is a very small sample, which makes it difficult to draw accurate conclusions.

As such, the theory could be attributed to data mining. In other words, if people are constantly looking at enough data for specific patterns, patterns can emerge, even if there is no significance to them. (For more insight, see Data Mining For Investing.)

As an example of this is the Super Bowl indicator, which has had reasonably good success in forecasting the market. According to this indicator, when an "original " team from the National Football League (NFL) wins the Super Bowl, the Dow Jones Industrial Average (DJIA) will rise in the following year. However, when a team from the upstart American Football League (AFL) wins, the market is predicted to fall. By some estimates, the Super Bowl indicator has predicted the DJIA trend correctly in 35 out of 44 years. (To learn more, read World's Wackiest Stock Indicators.)

Although the Super Bowl indicator may be a statistical oddity, the presidential election cycle theory appears to have some basis to it. It has been the subject of many academic studies that have attempted to prove or disprove it and to understand the reasons behind it. Most studies support the evidence of a significant relationship between the presidential cycle and the stock market.

A study published by the National University of Singapore in January 2007 entitled "Mapping the Presidential Election Cycle in the U.S. Stock Market" by Wing-Keung Wong and Michael McAleer found that "there were statistically significant presidential election cycles in the U.S. stock market during the greater part of the last four decades … stock prices decreased by a significant amount in the second year and then increased by a statistically significant amount in the third year of the presidential election cycle."

The relationship between the presidential election cycle and the stock market makes sense - the president has considerable impact on the economy through his policies and actions. For example, many people credit the tax cuts that President George W. Bush championed in 2003 for boosting economic activity and improving stock market performance.

Can Stock Markets Pick Presidents
Most studies on the presidential election cycle look at the relationship the presidential cycle has on stock prices. However, rather than the election cycle predicting a trend in stock prices, maybe the trend in the stock market can predict who will be elected president.

In a study done by John Nofsinger, "The Stock Market and Political Cycles," which was published in The Journal of Socio-Economics in 2007, Nofsinger proposed that the stock market can predict which candidate will be elected. He analyzed the relationship between the social mood of the country and the presidential election and concluded that when the country is optimistic about the future, the stock market tends to be high and voters are more likely to vote for those in power. When the social mood is pessimistic, the market is low and people tend to vote out the incumbent and put a new party in power. According to Nofsinger's research, the stock market returns in the three years prior to the election is useful in predicting whether the incumbent party candidate will be elected or whether there will be a new party in power at the White House.

Republican Versus Democratic Presidents
Although Republicans are generally considered to be more pro business than democrats, studies suggest that when a Democratic president is in the White House, it may be generally better for the stock market.

A research study called "The Presidential Puzzle: Political Cycles and the Stock Market" (2003) done by Pedro Santa Clara and Rossen Valkanof of the University of California, Los Angeles, demonstrated that the stock market performs better under Democratic presidents. Using data from 1927 to 2003, they found that the excess returns have been about 2% for Republican presidents, but 11% for Democratic presidents. Among small cap stocks, the difference is even greater. The bottom 10% of stocks as measured by market cap showed a difference of excess returns of about 22% for Democrats compared to when a Republican held the presidential office.

Furthermore, on average, the stock market volatility during a Republican administration was more pronounced than that during a Democratic administration.

Market Bottoms and the Presidential Cycle
Stock market cycles are well documented, with alternating bear and bull markets. When those cycles are superimposed over the election cycle, it is found that market bottoms tend to occur in the first term of a presidency.

In his study "Presidential Election and Stock Market Cycles," Marshall Nickels of PepperdineUniversity analyzed stock market bottoms in relation to the presidential cycle. In the period from 1942 to 2006, there were 16 presidential terms and 16 market lows corresponding to those terms.

Three of the lows occurred in the first year of the presidential term, 12 in year two, one in year three and none in year four. Of the 16 bottoms, 15 occurred in the first half of the term and only one in the second half of the term.

Rationale for the Presidential Election Cycle
Politicians are very astute when it comes to getting re-elected - if there is a relationship between voter approval and the state of the economy, you can bet they will capitalize on it. One of the assumptions that explains the presidential elections cycle theory is the rather cynical view that many of the policies that come out of the White House and elected government officials in general are done with the primary goal of getting elected and re-elected. The impact on the economy is a secondary consideration. Policies are motivated to keep the existing political party and its representatives in power.

In the first term after the election, presidents tend to focus on campaign promises and push through tougher legislation related to tax increases, government spending cuts etc. They push for policies that are more restrictive or disruptive and that might slow down the economy. By doing the unpopular things early, they hope that the electorate will forget about them by the time the next election rolls around.

In the second year of the term, the president may use fiscal stimulus, such as tax cuts or increases in government spending. The belief is that the people will feel better and therefore be more likely to elect that president or his party again. In the time leading up to an election, the pre-election campaign promises often create a mood of optimism among voter and investors alike. (To learn more read, Understanding Cycles - The Key To Market Timing.)

Monetary Policy and the Presidential Election Cycle
The Federal Reserve sets the monetary policy for the country. Although the Federal Reserve is supposed to be independent of the president and the Congress, monetary policy appears to follow the presidential election cycle as well.

In a paper entitled "The Presidential Term: Is the Third Year a Charm," prepared by the CFA Institute and published in the Journal of Portfolio Management in 2007, the authors found that monetary policy is more accommodative in the second half of a presidential term and more restrictive in the first term. These findings suggest that policy makers are reluctant to take a restrictive stance for fear it might slow down the economy in the months leading up to a presidential election. Of the four years, the third year is the year with the most expansionary monetary policy. During that year, the author found that monetary policy was expansionary 65% of the time versus 48% for the other three years.

Stock markets do well in periods of expansionary monetary policy and do relatively poorly when monetary policy is restrictive; therefore, it is no coincidence that the stock market is generally strong in the third year of a presidential cycle, when the Federal Reserve is in an expansionary mood. (For more insight, read Formulating Monetary Policy.)

Although the relationship between the presidential election cycle and the stock market appears to be strong, this does not mean it is going to play out the same way every cycle. However, when combined with other information, it can provide additional insights that investors can use to improve their investment decisions.

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