As Per The Script?

By: ContraryInvestor | Sun, Jul 1, 2007
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As Per The Script?...Boy, it sure looks that way at this point. So maybe we should not be so surprised at all that the markets of the moment appear to be in a one way levitating act, except for a few very short lived speed bumps now and again. If you can believe it, we're referring to the script of the US Presidential cycle for equities. Long time readers know we've referred to this in discussions over the years. It's time once again to have a little check in. We'll get right to it and start with a picture of historical experience. What you see below is the average of 56 years of Dow price performance split into four year blocks coinciding with the four year presidential cycles over this period.

Addressing our near term world, the pattern of the second and third year of the cycle is clear. An equity market rise into the Spring of the second year, a correction into summer, and then a blast off into the best of the four year cycle through the summer of the third year in almost straight up fashion. Does this pattern remind you of anything? It better. Just have a look.

Again, as incredible as it may sound when looking back across average half century of market history, from the equity market bottom in the summer of the second year of the presidential cycle to the peak in the summer of the third year, on average the Dow has levitated roughly 25%. Well wouldn't you know it, from the Dow lows last summer near 10,750, the DJIA is now up over 25% through the end of quarter. Right on cue. Can it really be this easy as to simply place our faith in the presidential cycle? At least in 2006 and 2007, it has been this easy.

Let's look at some numbers. When looking back across history, in general, it has been the period of Sept/Oct lows of the second year of the Presidential cycle through to a top in the first seven months of the third year of the cycle that have produced the best results in terms of market price appreciation. Of course the summer time lows of 2006 came in July, but let's face it, that's close enough. So in the following table we're looking back across historical experience to get a sense of rhythm. We're looking at the Sept/Oct low during the second year to the year end period of year number two. As you can see, in each and every case the Dow has produced positive returns, the majority of which have been double digit. So too was this the case in 2006.

Dow Industrials Price Only Performance
Second Year Of Presidential Cycle Second Year Sept/Oct Low To Year End Second Year Sept/Oct Low To High In First Seven Months Of Third Year Of Cycle Real GDP Growth Third Year Of Cycle
1955 19.8% (Sept Low) 42.1% (July High) 7.14%
1958 15.1(Sept Low) 26.4(July High) 7.11
1962 18.0(Oct Low) 32.2(April High) 4.37
1966 9.7(Oct Low) 29.4(July High) 2.51
1970 13.8(Sept Low) 29.4(April High) 3.36
1974 10.1(Oct Low) 54.0(July High) (0.19)
1978 3.3(Oct Low) 12.2(July High) 3.16
1982 18.9(Sept Low) 44.6(June High) 4.52
1986 5.0(Sept Low) 38.2(July High) 3.38
1990 9.9(Oct Low) 29.9(May High) (0.17)
1994 1.5(Oct Low) 25.0(July High) 2.50
1998 28.1(Oct Low) 47.9(July High) 4.45
2002 13.3(Oct Low) 30.2(June High) 2.51
2006 10.0(Sept Low) ? ?
AVERAGE 12.6% 34.0% 3.44%

We then look at the period, in the third column, of Dow price performance from the Sept/Oct lows of the second year to the highs in the first seven months of the third year. Again, consistent positive performance in each and every case, but under the microscope of this time frame, the numbers are big. Very big. As you can see, the average price performance from the second year summer/fall lows to subsequent first seven months top is 34%. If we were to mark the lows of the Dow near 10,700 in July of last year, that would imply a potential first seven months of 2007 top near 14,340 (a 34% average increase). As you know, this is really for illustrative purposes more than not. So far, we've stopped shy of this level.

One last note on the above table. For reference we have also displayed real GDP growth for the third year of the Presidential cycle in the final column. We did this because at least so far, 2007 is starting off with very low real GDP growth. 1Q GDP was terrible, but we currently expect a much better number for 2Q in light of current data, but you get the point. It's clear in the table above that really regardless of real economic growth in the third year of each Presidential cycle, Dow price performance has been hot. But as we dig just a bit deeper, the years of negative real GDP growth (1975 and 1991) were preceded by very weak equity markets in the prior year (second year of cycle). So as we look at current circumstances, we have clearly weakening real GDP growth in 2007 that was indeed preceded by a big up year for equities in the second year of the cycle (2006). For now, our experience in a weakening economic growth period set against the strong prior equity market move is different. In 1975 and 1991, prior weak equity market years were indeed anticipating and discounting economic weakness to come. In our current environment, it sure appears to us that the equity market never anticipated or discounted a slowing economy in the first place. Have we confused you enough? We hope not.

As we're sure you've guessed, we're simply trying to provide perspective here. Although we've recently seen a number of ardent bears turn bull as of late, and we see the dejection and give up psychology of the remaining bears right here and right now, we hope these numbers are a bit of a calming force emotionally. What we have been living through in the equity markets, certainly with the help of meaningful monetary accommodation, is nothing but a fitting experience with very well established historical Presidential cycle seasonal rhythm, that's all.

A few more numerical depictions of historical experience to help provide a bit more perspective. For a bit of a change up ball, this time we'll use the S&P 500 data. First, the history of total third year Presidential cycle price performance of the SPX.

S&P 500: Price Appreciation In Third Year Of Presidential Cycle
YEAR Price Return YEAR Price Return
1903 (18.4)% 1955 29.7%
1907 (33.2) 1959 10.4
1911 0.7 1963 18.4
1915 29.0 1967 17.2
1919 12.9 1971 10.1
1923 (2.6) 1975 32.3
1927 29.4 1979 12.2
1931 (45.6) 1983 17.9
1935 40.8 1987 (3.1)
1939 (2.5) 1991 18.2
1943 20.6 1995 35.0
1947 (0.7) 1999 20.1
1951 18.5 2003 20.2

What history suggests to us is pretty much crystal clear. In the last half century, there has only been one third year of the Presidential cycle period that has witnessed negative results for the S&P. The average third year cycle performance since 1955 is 18.4%. Again, in the wonderful world of make believe as per "what if this happened in 2007", an 18.4% increase for the S&P in 2007 would mean a target of 1,670. Again, we present all of this completely in the spirit of learning to accept and be at peace with whatever happens in the financial markets, and in the spirit of acknowledging the lessons of history, regardless of our personal outlook or beliefs.

One final look back at a quantitative issue. When you look at the first chart we displayed in this discussion, you'll notice that after the summer/fall high in the equity markets during the third year of the Presidential cycle, there has been a correction. What has this looked like from top to bottom for each period? In other words, IF we are to experience a correction some time this summer, what should we expect, on average when has it started, and how deep have these corrections been based solely on Presidential cycle experience past? Wonder no more as the following table lays it out.

S&P Price Only Data
YEAR Third Year Presidential Cycle Correction: Summer/Fall Top To Subsequent Bottom
1955 (9.7)% Sept High/Oct Low
1959 (9.2) July High/Sept Low
1963 (6.5) Oct High/Nov Low
1967 (6.6) Oct High/Nov Low
1971 (10.9) Sept High/Oct Low
1975 (14.1) July High/Sept Low
1979 (10.2) Oct High/Nov Low
1983 (6.3) Oct High/Nov Low
1987 (32.3) Aug High/Oct Low
1991 (4.1) Aug High/Dec Low
1995 (1.6) Sept High/Oct Low
1999 (12.1) July High/Oct Low
2003 (4.6) June High/Aug Low

Based on the numbers above, the average correction over the summer/fall period in the third year of Presidential cycles over the last half century is a drop of (9.9)%. But if we exclude 1987 as being a bit of an outlier, the average price correction drops to (8)%. From current levels as of recent highs on the SPX, that would imply a drop to about 1,420. Maybe the more important point is that, again on average, these corrections in the third year of the Presidential cycle have been relatively short lived. Just look how many of these occurred over one month or so. These corrections come fast. And that's certainly what we would expect in today's very highly leveraged markets. One pertinent question that we really do not have an answer for is, have we already seen the correction as per the Presidential cycle script? As you know, the hedge and proprietary trading desk magnitude of influence on the short term direction of the markets these days really has no historical precedent. And what drives home this point more than ever that the leveraged speculative investment money will determine market direction and the speed of acceleration or deceleration is the fact that the public really has not been participating in the equity rally since last July at all.

Since July first of last year, total US inflows to domestic only equity funds has been negative (to the tune of about $35 billion in net outflows). In the spirit of honesty, the public has been buying foreign funds and ETF flows have been positive. Funny thing is, with a domestic market run such as we have experienced since last July, it's very uncharacteristic of the US public not to be drawn like moths to the flame of investment performance. Stepping back just a bit, you'll remember the Hank Paulson quote we've shown you a number of times from the Fortune Magazine interview late last year. The bottom line is that Paulson is pointing to stock price increases as having offset the decline in residential real estate values. But will it work is the important question. We'd suggest that Paulson is not getting his wish in that the public has not been following the script of history. They are not throwing money at the equity markets as they have been rising. That leaves us looking at perhaps two potential outcomes yet to materialize. Either the public indeed wakes up and starts throwing money at the US equity market hand over fist to finally "get in on the action", or the public simply is not going to show up, implying they are short on the ability to invest (cash). In very simple terms, it seems it's either one of the two. As you'd guess, we'll be updating you on this more frequently ahead given the importance of the answer to the question regarding public activity in US equity funds. Does this help explain the character of the equity market over the past year? We hope it helps. Remember, the markets are never right or wrong. The key to successful investment over time is to remain unemotional.




Author: ContraryInvestor

Market Observations

Contrary Investor is written, edited and published by a very small group of "real world" institutional buy-side portfolio managers and analysts with, at minimum, 20 years of individual Street experience. Our credentials include CFA, CPA and CFP, as well as the obligatory MBAs in Finance. We are all either partners or employees of institutions with at least $1 billion under management.

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