Declines in Year 2 often Precede Year 3 Gains

The next six months will be interesting to watch. With investors showing confidence in the nascent recovery and above-average valuations now priced into stocks, the market is now heading toward a part of the calendar that historically has delivered weak returns to investors.

A few years back, I noted how the most distinct election cycle returns don’t actually overlap with the calendar year. While the average return during the third calendar year of a presidential term is above average, the twelve-month period beginning with the fourth quarter of the second year of a presidential term is the true standout. Going back 60 years, the average annual total return for the S&P 500 during this period has been 28 percent.

Many causes have been offered up to explain the election cycle performance, usually focusing on fiscal or monetary policy decisions. But when you look through the economic data, strong and dependable trends don’t jump out. One of the better explanations turns out to be the price action that is frequently seen during the second year of the presidential cycle, especially during the April to September period (which is the part of the election cycle that we just entered). Frequent declines during this period often set up the strong 12-month period beginning in the fourth quarter of year two.

The graph below shows the average return during each quarter of the election cycle. For example, the average return during the 1 st quarter of the second year of the cycle – the quarter that has just ended – is little more than 2 percent. The graph shows the strong average returns that have occurred during each of the four quarters beginning in the fourth quarter of year two. The first three quarters of this period are the strongest three-month periods in the cycle when measured this way. But look at the two quarters that precede these gains. These are the two worst quarters in the cycle, on average.

When you look at the individual quarters that make up this poor six-month period, an interesting pattern emerges. Not all of the periods are negative. And some of the periods have strong double digit returns. What explains the difference between the positive and negative outcomes? Part of the explanation can be attributed to the market’s valuation at the beginning of the April-September span of year two.

The graph below shows the comparison of valuation and six-month returns. The P/E multiple is from the end of March for each 2 nd year of the election cycle. The six-month return reflects the total return of the S&P 5000 for the 6-month period ending on September 30 of each 2nd year.

In general, higher levels of valuation markets have resulted in weaker performance during this period, on average, while the market has done well from lower valuations. The data doesn’t line up perfectly. Low valuations don’t always help, as investors found in 1974, and high valuations don’t always hurt, as investors found in 1994 and 2006 (although returns were still uninspiring). But it is worth noting that all of the strong returns during the April-September period of the second year of election cycle occurred when valuations were below average (typically below a 14.5 CAPE, the cyclically adjusted P/E ratio, where the denominator is the 10-year trailing average of S&P 500 earnings).

Big declines have tended to occur from higher levels of valuations. With a CAPE of 22 currently, there are only four periods that were more expensive than the current market, heading into this generally unfavorable six-month period of year 2. The average return that followed these periods was -11 percent, and it includes 2002 where the market fell by almost 30 percent.

Calendar cycles are an interesting backdrop in which to frame the analysis of other characteristics of the market, like valuation and market internals. We don’t rely on calendar cycles in setting investment policy, because it is difficult to identify cause and effect mechanisms that would make these tendencies reliable (the links between valuations, market action, risk premiums and investment returns are clearer). Also, the average returns presented above can hide a lot of variation in the individual outcomes.
Even so, it might be worth keeping in mind over the next six months that this part of the election cycle has been mostly unkind to investors, and the more steeply valued the market, the less kind the market has tended to be.

via John Hussman http://hussman.net/rsi/buselectioncycles.htm