Rethinking the Presidential Election Cycle
Last year the chorus from bearish market pundits was that 2006 should be a down year for stocks because of the Presidential Election Cycle. At "A Dash" we have never quite understood the theory behind this. It is vaguely stated as incumbents doing something to stimulate the market before the election. This means a negative second year of the cycle and a strong third year. There are several problems:
- Why this should happen a year before the election is a mystery. Voters do not focus on the election until later.
- Why is it supposed to work when there is a lame-duck President?
- Why should it work when there is split control of the executive and legislative branches?
- Recent successful third-year results were in 1999 (advance run-up to Y2K) and 2003 (relief rally after Iraq invasion). The fact that these happened in the third year of a Presidential term was random.
The problem with looking at data without any hypothesis or causal model is that there is no real understanding. Most of Wall Street Research is done this way. An army of researchers does data mining, looking for patterns, and getting "fooled by randomness." There are always some patterns. This is not how any serious student of methodology conducts research, as we described in our discussion of the "old days."
Because the underlying theory was not developed, we were amused that so many perma-bears embraced this cycle as part of their predictions for the market in 2006. What would happen when the cycle predicted a good year? To our amazement, many pundits viewed this "cycle theory" as fundamental analysis. (Please check our series on valuation and the Fed Model for our idea of fundamentals — projected earnings and interest rates).
Last September, we predicted that bearish pundits would not change their views because of the election cycle, but would instead find a way to reject the forecast. Check out the story: You Heard It Here First.
We now have our first entrant in the "rethinking the Presidential Election Cycle" sweepstakes, Ed Stavetski of thestreet.com’s Street Insight. This is the excellent premium service for serious investors and money managers. Ed, like nearly everyone writing for Street Insight, is a sharp guy with a lot of good ideas about specific stocks, especially those in the energy sector. He covers a lot of companies on earnings reports in a highly professional fashion. His market view, however, is colored by the idea that analysts are way off on earnings estimates. He is a charter member of the group that is Fighting the Last War, not realizing that the 2000 era of hype has come to an end.
In December of 2004, more than two years ago, Ed wrote as follows:
However, lurking around the corner is a stark reality. The yield curve
is flat and investors have traded risk premiums in favor of yield and
return. Consequently, investors are gravitating to lower-quality
investments in search of return. Sometime in early 2005, the flat yield
curve will give way to the economic slowdown it is forecasting, and
quality and credit spreads will snap back. Earnings estimates will be
slowly adjusted downward.
The operative word must be "slowly" since earnings estimates continued higher and actual results regularly beat the raised estimates as the string of double-digit earnings gains continued. In 2005, Ed thought he caught a whiff of stagflation. He has repeatedly opined that earnings estimates will move lower. Ed’s latest market comment is as follows:
The double-digit earnings trend seems to be going out with a bang and
not a whimper. Companies that are not meeting or surprising on the
upside seem to be getting rather harsh treatment from the markets. I
suspect that as earnings estimates begin to be reduced, the expectation
that there will be a multiple expansion in 2007 will shrink along with
it. M&A and the possibility of a rate cut by the Fed may be the only positive forces for the year.
The problem with this view is that it represents an extremely negative spin on normal data for a time in which the Fed seeks to get the economy on a non-inflationary Glide Path. There is no indication that earnings are declining — just that the rate of increase has slowed. Furthermore, there is no indication that earnings are coming in below estimates.
This kind of analysis is part of the ongoing Cycle of Negativity. If reporting companies do not rave about their prospects, the Street’s hot money hedge fund managers quickly look for the next new thing. Money flows from energy to technology to retail without much fundamental analysis. It is all about calendar cycles and trying to outguess everyone else for the next trade.
It represents a great opportunity for individual investors who have a longer time frame and are willing to ignore some of the fluctuation.
Meanwhile, we continue to predict that more bears will dump the Presidential Election Cycle theory, finding some excuse for why this year is different. Ed Stavetski wins the prize for being the first that I have spotted. (Readers are invited to submit other entrants). Ed’s idea is that since candidates are announcing earlier and primaries may be moved up, the cycle was advanced by a few months. He did not go on to explain how the campaigns of Obama and Clinton are stimulating the market, but perhaps he will soon elaborate on this intriguing theory.
I lost an office bet to Ryan, my savvy young associate and an excellent trader. I predicted that Barry Ritholtz would win the prize as the first to come up with a creative reconstruction of the election cycle theory. It seemed safe. Barry featured this premise last year, and he is the very best at articulating creative bearish views. Ryan wisely took "the field" at even money. He has graciously allowed me to press my bet, so I am counting on Barry to join Ed in renouncing the election cycle some time within the next month. We’ll be watching!