Obama's Learning Curve: Will the President Absorb a Key Lesson of Market History?

Whether you like or loathe him — everyone can agree President Obama’s term had a bumpy start — at least for markets. His first few months coincided with spiking volatility. Starting with his inauguration, stocks sold off sharply. Then, starting March 9, they rebounded heavily. Those who dislike Obama blame him for the sell-off, while supporters give him credit for the rebound. In a sense, they’re both wrong and right.

Investors fear Obama’s big budget means tax hikes and ballooning debt, which they commonly believe spell market disaster. Many Republicans call his policies socialistic and warn of the ills of a non-free market economy. Some just generally fear a Democrat’s impact on stocks overall. Of course, a Democrat will claim the reverse — saying Democrats ultimately are better for the economy and therefore stocks. And either party can slice and dice historic data to support its side by leaving in or out a few years. But the fact is, calculated correctly, neither Democrats nor Republicans are overall much better for stocks through history.

That doesn’t mean party doesn’t matter. It does — but not as most envision. What matters most isn’t stereotype and rhetoric, but how markets perceive politicians, and what politicians then ultimately do — which is often precisely opposite of what they say. Though, overall, neither party is better or worse for stocks, there is one very clear and surprising but fundamental pattern based on both election and first years (like 2009) which you won’t have seen elsewhere in print.

Politically, President Obama’s and Congress’s effect on stocks will depend largely on how good a political student Obama is. There is no adequate preparation for being president and Obama clearly has less experience than any in a century. If Obama is a fast on-the-job learner, it impacts stocks more positively and if he is a slower learner, expect a more negative effect. Ultimately — that’s up to Obama.

So what’s most likely? Check history — specifically, presidential history.

Presidential Term Anomaly

You’ve likely heard pundits reprove the so-called “presidential term cycle” as patent nonsense — which is good for you. As detailed in my 2006 book, “The Only Three Questions that Count,”falling prey to widely held beliefs can mean missing profitable opportunities. Things most folks widely believe frequently turn out to be baseless myth. And things most scoff at — reject as silly or even voodoo — can be powerful. Patterns that are widely known and easy for all to see — like the obvious pattern of four-year president terms — but are still soundly rejected can be very powerful.

That book’s second question was: What can you fathom that others find unfathomable? Apply that question to something you know most won’t because they mock it — presidential terms and annual stock returns — and a prime pattern emerges. Chart 1 shows all annual U.S. stock returns since 1926, divided into presidential terms, lined up by first, second, third and fourth years, designated “R” and “D” for Rummies and Dummies. (I’m nonpartisan.) Negative years are highlighted. What can you see? Most apparently, the first two years of presidents’ terms have a disproportionate number of negative years, whereas the last two are more uniformly positive with fewer negative years and better overall averages.

Interesting, but does it mean anything? Unexplained patterns are everywhere — but that doesn’t mean you can bet on them. Before making market bets, try seeking an explanation rooted in fundamental economics. Otherwise, you may have nothing more than statistical flimsy whimsy. For example, overall it looks like Democrats do better than Republicans. But if you take out the Hoover years and the first FDR term with the down and up of 1928-32 and 1933-37, most all of that disappears.

The first half/back half pattern is rooted in the very fundamentals of how politicians operate — and how markets respond to them. Presidents are good at elective politics or they wouldn’t be there. They know that, throughout history, presidents always lose relative power in midterm elections — whether first or second term (a rule George W. Bush overcame in 2002 but not 2006 — the first Republican to so do in over 100 years).

Any major legislation, the most onerous of his (or her) presidency, the landmark of their administration must therefore be pushed through in the first two years when there is more congressional support. Presidents know they must pass it then, or not bother, because it’s less likely to pass in the back half with less backing from the president’s party. With few exceptions, big legislation has happened in the first two years.

And legislation always — yes, always — results in redistribution of money, property rights or regulatory status (which is really another form of property rights). Money (or rights) gets taken from one group and handed to another group. To humans, a loss provably feels more than twice as painful as a gain feels good. This is what behavioral finance calls “myopic loss aversion.” Those on the legislative winning end feel much less good than the losers feel bad. So, overall, we feel worse than if nothing happened. Those not involved feel like they’ve witnessed a mugging and fear they’ll get hit next. So risk aversion increases in the first two years when big legislation is likely, leading to more return variation and poorer average returns.

But in the third and fourth years, presidents can’t pass much controversial legislation with weakened support. Less risk of legislated wealth redistribution means less risk aversion so we feel better and generate more uniformly positive stock markets. Of course exceptions can happen — like 2008. Third years are best of all — averaging 17.5 percent without one negative year since a barely down 1939 as World War II began. As presidents grapple with less relative power and both parties start thinking about reelection posturing, third years aren’t a great time for introducing controversial, redistributive legislation that valuable independent voters will remember and dislike.

Fourth years do well, too — averaging 9.4 percent but see less optimal returns than third years because markets begin pricing in heightened election rhetoric. Clinton’s second term had a negative fourth year. But recall the 2000 election wasn’t decided until mid-December — uncertainty reigned all year. And 2008 was hugely negative, tied to all the factors you know — which swamped the election’s impact.

Note too, when the first two years weren’t negative, they were often up huge. Because the averages are poor doesn’t mean returns must be. Rather, if markets expect a massively negative political effect but it doesn’t happen, that can be a powerful positive to push prices higher.

Interestingly, though this is a U.S. election cycle, similar patterns appear in world stocks with similarly high return variability in the first two years of U.S. presidents’ terms. Global stocks are also more uniformly positive with better returns in years three and four. This isn’t a fluke. Globally, stocks have been more correlated than you think, longer than you think, as I documented in my 1987 book, “The Wall Street Waltz.” U.S. and foreign stocks, in aggregate, have tended to go the same way more often than not — not in the same magnitude but usually the same basic direction.

Because U.S. stocks make up almost half the world stock market, U.S. legislative risk aversion will bleed out to impact overall foreign stocks. But it works in reverse, too. America is big, but the whole world is bigger. And in 2008, global forces of credit crisis and recession fear simply swamped the fourth-year effect at home.

Hence another lesson: No matter how powerful a pattern and how persuasive the fundamentals behind it, nothing works all the time. Said simply, all else being equal, this pattern has a long history and is powerful. Stocks generally want to be positive more than not in the back half, and in the front half, there’s heightened risk aversion and big return variability.

Deeper, Unknown Pattern

But there’s another pattern within the data. Election years when presidential power switched from Republican to Democrat — like 2008 — have seen overall worse returns, averaging minus 2.8 percent. But switches from Democrat to Republican have better election years, averaging 13.2 percent.

Why? During campaigns, Republicans typically say free-market and business-friendly things and are generally seen as pro-business and pro-free-market. Markets like that. But Democrats tend to be seen as more business-unfriendly and anti-free market, which scares markets.

Then something changes in inaugural years — year one. Party impact reverses on election night when the newly elected president starts thinking about what he must do to get reelected.