The rising power of the Federal Reserve has rendered the presidential cycle of market investing largely dead, according to Jeremy Grantham, the chief investment strategist of asset manager GMO.

“They are constantly looking for excuses to push down on interest rates and drive asset prices higher to get some wealth effect. I don’t trust them any more to play the easy presidential cycle,” Grantham said in a recent interview with the Financial Times.

The GMO founder, based in Boston, has shown through research dating back to 1932 that the third year of a president’s term could top those of the other three years of their leadership.

On average, U.S. stocks improve about 0.2% each month in the first, second and fourth years of a presidential cycle. However, in the third, stocks return an average 0.75% to 2.5%.

“The presidential cycle owed everything to the Fed. The Federal Reserve, completely innocently, always decided to come to the aid of the party in power,” said Grantham.

The general theory he has described entailed revving up the economy in the third year of a president’s term, so that the economic benefits would be felt as votes were cast in the fourth year. Stock markets, which generally signal anticipated economic developments, tend to move up ahead of this growth in year three, according to Grantham.

The Federal Reserve board members did not take action to stimulate the economy earlier in the cycle “or everyone would have forgotten about them by year four,” he states.

“The Fed can move stock prices. In the old days it was about all they did. They helped along year three, and their efforts in year three would feed through into the economy in year four -- which it did,” Grantham told the FT.

David Fuller's view

I think Jeremy Grantham is right, although I have not previously heard this view stated so definitively.  However, veteran subscribers may recall me writing about this cycle in previous decades.  Beyond a brief post-presidential election honeymoon, I used to describe the first two years of a new four-year cycle as equivalent to Hercules cleaning the Augean Stables. 

Around 2H of the third year of the presidential election cycle, the Fed would commence stimulating the economy once again.  This often provided a decent bull run which was particularly strong from the low point in the third year through yearend of the election year.  Of course all things being equal, which they seldom are due to endless variables and permutations, any market cycles beloved by some analysts are likely to be imprecise.

Nevertheless, a look at this 10-year weekly chart of the S&P 500 Index shows a sharp dip in 2015, the pre-election year, followed by a rally during most of 2H 2015.  However, 1Q 2016 was certainly a negative surprise in terms of the presidential election cycle, before a respectable election year rally followed.  Looking back at the previous cycle, we see a sharp dip in 1H 2011 (the third year) before a good rally in 2H which continued throughout most of 2012 (the election year).  There was certainly no cleaning of the Augean Stables in 2013 or 2014 because the Fed was highly stimulative. 

Looking back even earlier, we can see that 2007 (the pre-election year) was choppy and 2008 (the election year) a disaster, followed by a strong rebound from 2Q 2009.  Consequently, you may wish to keep the US presidential election cycle in the back of your mind, but I would not count on it, unless other factors are similarly in line.  The odds of that being the case are perhaps slightly better than 50/50 over time. 

This begs the question: will we see a cleaning of the Augean Stables in 2017? My guess is perhaps not initially but if the Fed adds three more rate hikes next year… yes, probably.