Political wheel of fortune: Is Wall Street tied to presidential cycle?

For the last 30 years, especially during elections, investors have speculated about the apparent link between stock market behavior and the U.S. presidential election cycle. To the observer, returns seem to be higher during the second half of a president's term than the first. Is it true, or has this phenomenon been merely an intriguing coincidence? A W. P. Carey School of Business finance professor analyzed market behavior going back to 1803 and confirmed that the pattern is real. The reasons why are not so clear.

When it comes to the stock market, everyone wants a sure thing. Over the decades investors have relied on everything from skirt lengths to Super Bowl winners to predict market cycles.

Since the 1970s one theory that has consistently resurfaced — usually around election time — is the presidential cycle. The premise: stock market returns are higher during the second half of a president's administration than in the first. While innumerable pundits have alternately regaled or discredited the theory, James Booth, a finance professor at the W. P. Carey School of Business, decided to delve a little deeper.

"We wanted to test the Wall Street adage by considering macroeconomic variables to see if they could explain away the presidential cycle," he said. So Booth and his co-author, Lena Chua Booth of Thunderbird, The Garvin School of International Management, developed a model to formally analyze whether the pattern could explain stock returns or was merely a reflection of the business cycle.

Given that presidential administrations span four years, Booth reached back to 1803 to develop a reliable model. Because early data is less complete and reliable than later information, Booth's in-depth analysis focuses on the period after 1926, the first year for which the Center for Research and Securities Prices collected data for both large and small capitalization portfolios.

Booth likewise pays particular attention to the period following passage of the Full Employment Act of 1946, the point at which government began to take a more active role in the economy. Data wasn't the only stumbling block. Because market performance can be sliced and diced numerous ways, the researchers needed reliable indicators to gauge economic conditions. They selected three traditional measures — term spreads, dividend yields and the default spreads — as proxies for economic conditions.

What they found was that the presidential cycle appears to have an impact on total market returns independent of economic considerations. The effect prevails regardless of a president's party affiliation or incumbent versus non-incumbent status.

Indeed, during the entire 194 years studied, Booth found average annual returns during the third and fourth years of the presidential term were 12 percent, almost twice as much as the 6.4 percent reported during the first two years. The pattern became even more pronounced after 1926 and smaller stock portfolios seem especially susceptible, particularly after 1946.

Exactly why the cycle should have an effect on returns is a matter of speculation, says Booth, who refrains from participating in the parlor games his research is wont to inspire. Although his research demonstrates that Fed policies and interest rates don't explain the cycle, other possibilities abound.

Like many others, Carl Steidtmann, chief economist for Deloitte Research, attributes the pattern to incumbent opportunism. While the administration might toe the line during the early quarters, it begins to loosen the fiscal reins as election time approaches.

"Politicians, particularly in a presidential election year, have incentive to get the market going and the markets react accordingly," he says.

That holds true regardless of party affiliation. "I think, in the end, incumbency trumps even political ideology. Incumbents know they have to have some kind of [positive] results to show for their time in office."

Constantine Spiliotes, a research fellow at the New Hampshire Institute of Politics, isn't convinced. Spiliotes, who approaches the topic from a political vantage, says presidents are more often the servants of the economy than its masters. The presidential cycle presents a classic quandary for students of the political economy, says Spiliotes, author of "Vicious Cycle: Presidential Decision Making in the American Political Economy."

"One of the frustrations we face is people notice economic patterns and make a lot of backwards inferences about political actions to explain them. People naturally want to know, 'Who's driving this bus?' Is it the Fed chairman? The president? Someone else? There's a lot of interesting speculative literature trying to explain these patterns, but I don't sense that there's a lot of stuff that looks at the underlying logic. The reality is the president's ability to drive the market is probably even more imperfect than his ability to affect economic factors such as unemployment."

If fiscal policy can't account for the phenomenon, it might be tempting to conclude that investors are at the wheel. The stock market rues the unpredictable. As a result, the first two years of the presidential cycle might reflect investors' wariness toward a new administration while the second half might reflect their growing comfort level with a president with whom they've become more familiar.

"Some presidents come in with ambitious agendas and the financial markets don't really want that," explains Booth. "As one Washington insider once said, 'The great thing about Washington, D.C., is that not much gets done there.' That seems to be the markets' preference. There's a perception that any time the governments gets involved in the private sector it tends to mess things up, and the presidential cycle might reflect that thinking."

Alternately, he posits, "the high stock returns in year three and four [could] reflect investors' confidence and optimism about the upcoming elections, anticipating that the new government [or a new president] will bring new prosperity to the marketplace." Investor psychology isn't the only wild card in the equation.

The lag between presidential action and economic effect presents another sticking point, notes Ed Easterling, founder of Dallas-based Crestmont Research and author of "Unexpected Returns: Understanding Secular Stock Market Cycles." Many Republicans argue that Ronald Reagan's economic policies accounted for the economic prosperity of the 1990s while Democrats will contend that Jimmy Carter's second presidential bid was crushed by economic forces put into play by his Republican predecessors.

What's more, although referred to as the "presidential" cycle, the phenomenon might be correlated with midterm Congressional elections. Booth and Easterling both note that it would be telling to see how party control within Congress impacts the cycle.

In the long run, determining the roots of the presidential cycle may be more fodder for cocktail-party debates than academic research. Whether it reflects behavioral finance, captures some economic factors that were not captured by his model's business proxies, or violates market efficiency, the presidential cycle is likely to remain mysterious, Booth says. That's because academic models simply can't accommodate wars, investor psychology, catastrophic events like Sept. 11, and all the myriad forces that impact the market.

Even if they can't account for it, however, Wall Street pundits and investors aren't likely to dismiss the presidential cycle out of pocket. While other theories, like skirt lengths, may ultimately go out of style, the presidential cycle is likely to stay in vogue. "If we were at a cocktail party and I brought up the Super Bowl cycle, you'd probably laugh at me," says Easterling, "but if I brought up the presidential cycle it would have credibility. There's a fundamental basis for the theory."

Even if no one can explain it.