From the November 2013 issue of Research Magazine • Subscribe!

October 28, 2013

Beware the Obama Stock Bubble

Presidential history reveals an ominous financial pattern

Ronald Reagan’s presidency will be remembered for many achievements, one of which was to break the so-called Tecumseh’s Curse.

Starting in 1840 with President William Henry Harrison—who some years previously had fought in a battle in which the great Native American chief was defeated—every American president elected in a year ending in zero died in office. Seven such presidents later, Reagan—who, at nearly 70 years of age, became the oldest man to move into the White House, and survived an assassination attempt—nevertheless completed his two terms. Since then, George W. Bush, elected in 2000, also served eight years, confirming that the old spell had been broken.

But Reagan may have started a new curse that dogged him and then every other president elected for two terms thereafter. Every two-term president since Reagan has followed the same pattern, assuming the presidency in a business downturn or even severe recession inherited from his predecessor, then presiding over a recovery or strong economic boom and ending up with a financial bubble that burst not long before he left office. Barack Obama is now in danger of following in their footsteps.

Early Warning

When Reagan was elected president, inflation was running at a double-digit pace with little precedent in U.S. economic history. It was combined with the highest rate of unemployment in the post-World War II era and, to use Jimmy Carter’s words, a “crisis of confidence” (in what is remembered as the “malaise speech”).

(Check out Marc Faber: 3 Reasons a Crash Is Coming on ThinkAdvisor.)

Economic reforms implemented during the Reagan era jump-started the economy and freed it of excess government regulations and oversight. The stock market, which had been in hibernation throughout the 1970s, took off. Starting below 800 in mid-1982, the Dow Jones industrial average broke through the 2,000 mark in early 1987, representing a 150% gain for investors in four and a half years.

Then, almost a year before the 1988 presidential election, the Dow suffered its largest one-day drop in history, falling 22.6% on Oct. 19, 1987. It was a carnage that raised the specter of 1929, and many analysts feared a rerun of the Great Depression scenario. However, the seemingly catastrophic market drop proved to be a non-event as far as the real economy was concerned. Alan Greenspan, recently appointed chairman of the Federal Reserve, pumped extra liquidity into the markets. The bottom held, economic activity didn’t stall and by early 1988 shares began to recover. Even though it took two years for the Dow to return to its pre-Black Monday’s levels, the market meltdown had no major impact on the U.S. or global economy.

However, it proved a harbinger of events to come, presaging the boom-bust pattern in financial markets that has bedeviled two-term presidents ever since. After George Bush, president 41, failed to win a second term, Bill Clinton’s presidency began in the midst of an economic downturn, though it was milder and less entrenched than what Reagan had faced.

Dot-com Debacle

Once again, the economy righted itself under a new president. The technology revolution created what was then known as a “new economy,” resulting in an entrepreneurial boom on the Internet and a labor shortage. On the strength of this economic performance, Nasdaq rose sevenfold in only six years, to over 5,000. But after reaching a peak in March 2000, the dot-com bubble burst spectacularly in the final year of Clinton’s presidency. The tech index went down to nearly 1,000 by late 2002. By then, the Dow had also come off the boil, ending the market’s longest bull run.

Enter George W. Bush, president 43, who was elected in time to deal with the economic mess produced by the bursting of the market bubble. The economic downturn was exacerbated by the Sept. 11, 2001 terrorist attacks, but by 2003 a combination of massive tax cuts, easy monetary policy and government spending on military operations and domestic security got the economy back on track.

Growth soon became robust, stoked by the residential housing sector, which allowed consumers to supplement their incomes with cheap and convenient borrowing against the accumulated equity in their homes. That seemed like yet another El Dorado, since everyone knew that house prices never go down and that homeowners rarely default on mortgages.

Once again the Dow hit a record in 2007, but the end of Bush’s second term was marked by a spectacular bursting of the housing bubble and a massive financial crisis. The ensuing recession was the worst since the Great Depression and many of its effects endure more than four years into a recovery.

Here We Go Again

Obama, like his three two-term predecessors, inherited an economic mess and has been able to engineer a recovery. But growth has been patchy, at best. The U.S. labor market has almost two million fewer jobs now than at the turn of 2008. The size of the labor force has been stagnant even though the population has increased by more than 12 million meanwhile.

But the recovery on Wall Street has been complete. Near-record profits, low interest rates and plentiful liquidity have pushed the Dow to yet another new high, and even on Nasdaq, after nearly a decade and a half of doldrums, eye-popping P/E ratios are back.

On past experience, we can expect the bubble to keep inflating for another three years and burst by 2016. Given the pace of stock market growth, we may be in for a bone-rattling ride.

This too would fit the pattern—bigger bubbles and more wealth creation followed by increasingly severe downturns. The question is why, and whether the pattern is actionable, allowing investors to cash in on the repeating boom-bust cycles of two-term presidents.

Economic reforms, structural changes and the entrepreneurial and tech revolution aside, there have been two factors that stimulated the U.S. economy under all those presidents: profligate fiscal and monetary policy. The Reagan presidency featured tax cuts and increased government spending, notably on defense. He did inherit a messy economy, but Jimmy Carter left him gross U.S. government debt at just 32.5% of GDP. During Reagan’s presidency, gross debt to GDP rose by some 20 percentage points.

During the Clinton years, Washington ran a budget surplus and government debt declined. However, this happened only during Clinton’s second term. In the first four years of his presidency, the federal budget deficit remained substantial, helping pull the U.S. economy out of the economic slowdown. It was accompanied by extremely easy money. The overheating of the high-tech boom was a major factor in boosting federal revenues and closing the budget gap.

The Bush 43 administration, for its part, stimulated the economy with tax cuts and with defense and security spending at a time when the bursting of the tech bubble had already started to eliminate fiscal surpluses. While a burst of fiscal stimulus helps the real economy expand, it provides even more fuel for the stock market, especially in an environment of lax monetary policy.

In the Obama years, both fiscal and monetary stimulus reached a crescendo. The economy has been anemic, but stock prices have taken wing. Wall Street sees itself protected by the so-called “Bernanke put.” Not only have interest rates been at zero throughout the Obama presidency, but the Fed is actually printing money to the tune of $85 billion per month in order to buy Treasury bonds and other financial assets as part of its quantitative easing program. Fed Chairman Ben Bernanke is expected to support stock prices regardless of how high they go.

The 2013 stock market rally may be the biggest of the presidential rallies—the Dow has more than doubled from its 2009 nadir to its current record—but it may also be based on the most tenuous foundations. Meanwhile, fiscal stimulus appears to have reached its limit, as evidenced by bitter political fighting in Congress. This opens the way for a continued run-up in stock prices and then for a spectacular, possibly open-ended, bursting of the Obama bubble.

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