Originally created 11/24/03

Does the 'presidential market cycle theory' really work?

Q. I'm looking to buy some stocks, and I heard about the "presidential market cycle theory" which is supposed to be a good gauge of when the market will do well. What's the theory, and does it really work?

A. The presidential market cycle theory argues that the stock market moves somewhat predictably in relation to a presidential term. Still, while the theory appears to generally work, no investment strategy is completely foolproof, financial advisers say.

According to the theory, the third and fourth years of a presidential administration tend to register the strongest stock market gains as the incumbent government cuts taxes and increases the money supply in hopes of boosting the economy and keeping its political party in power.

In contrast, in the first and second years after a presidential election, stocks tend to lag while presidents make tough decisions about the economy that they hope voters will forget about by the time of the next election, such as taxes and regulation.

"There's this manipulation and juicing of the economy by a president trying to get back in office," said Jeff Hirsch, publisher of the Stock Trader's Almanac.

Indeed, since 1941, the average percent gain for the Dow Jones industrials is 3.9 percent in a post-election year, 4.9 percent during the midterm, 16.7 percent in the third year, and 7.3 percent in the year of the election, according to the Stock Trader's Almanac.

Hirsch said the current presidential cycle seems to be holding true to the theory, with the Dow suffering losses during the first two years of the Bush administration during a grueling bear market.

And so far in 2003, the third year of the presidential term, the Dow has climbed about 28 percent, thanks in part to fiscal tax cuts and the Federal Reserve cutting short-term interest rates to a 45-year low. Many analysts believe 2004 will also see some stock gains, although they may be more modest as the tax cuts and low interest rates lose effect over time.

But investors can't count on surefire market gains. Hirsch notes that since 1900, the Dow has gained 15.8 percent when a political party retains the White House, but fell an average of 1.4 percent when its candidate lost.

The rationale: Investors unhappy with the economy sell their stocks shortly before they vote to dump the party's candidate, too.

He added that Bush might be vulnerable since a president who lost the popular vote has never won a second term, while the Fed might be forced to raise interest rates in 2004 to stave off inflation, a move that would likely depress the market.

There also have been times when the stock market defied the market cycle theory: In 1984, despite Ronald Reagan's landslide victory, the Dow suffered a 3.7 percent loss because the market had already experienced a large runup and didn't have strength to move higher.

The stock market during the presidential cycle is "predictable on a broad basis, yes, but to the day and month, no," Hirsch said. "There are too many things going on in the world and in the market and economy."

So what should investors do?

Eric Tyson, author of "Investing for Dummies," said it doesn't hurt for investors to take the theory into account when making purchasing decisions so long as they don't rely solely on it.

But more important things to consider are finding a good mutual fund, maintaining a diversified portfolio and dollar-cost averaging, or purchasing in fixed amounts at regular intervals, to safeguard against major losses, he said.

"The theory is a good thing to know about and keep in the back of your mind," Tyson said. "But you shouldn't buy in just because everyone looks like they've having a party. ... No one rings a bell when you hit a market bottom. And if you sit it out too long, you can miss a major rise."

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