Returns in the second half of each U.S. Presidential Term far surpass the returns in the first half (as noted in my previous column). This “calendar anomaly” is one of the prominent, persistent and puzzling examples of market inefficiency, reaching back over two centuries of American political and financial history.

The structure of the cycle is quite distinct.

Gains Are Concentrated in Year 3

  • In 13 election cycles (1954-2006), the U.S. stock market returned an average of 23.5% in the third year of the Presidential cycle
Equity Returns by Year of the Presidential Term
Source: Equity Returns by Year of the Presidential Term.
  • In the most recent Year 3 (2019), the market gained 27.6%.
  • Since 1928, Year 3 has ended in positive territory 82% of the time.
  • Even Gold prices have tracked this cycle
Presidential Calendar Cycle in Gold Prices
Source: Presidential Calendar Cycle in Gold Prices.

Losses Are Concentrated in Year 2

  • The low point in the U.S. stock market occurred most often in Year 2 (1952-2000)
Year of the Presidential Term in Which the Market Low was Reached
Source: Year of the Presidential Term in Which the Market Low was Reached.

An Investment Strategy

One intriguing study compared the performance of two market portfolios based on simple switching strategies. Investor 1 entered the market on January 1 of Year 1 (the inaugural year), and stayed in until Sept 30 of Year 2. Then he exited the market and sat out Years 3 and 4. Investor 2 did the opposite: she entered the market on Oct 1 of Year 2 and stayed in until Dec 31 of Year 4. She then exited and remained out of the market for Years 1 and 2.

The results were spectacular. Investor 1 started with $1000 in 1952, and ended with just $643 in 2004. Investor 2 started with the same $1000 stake – and was worth $72,701 in 2004! By harvesting the gains of Year 3, and avoiding the losses of Year 2, Investor 2 saw a return of over 7000%. (Investor 1 lost more than a third of his original investment.)

Comparison of Year 1/2 Investor vs Year 3/4 Investor
Source: Comparison of Year 1/2 Investor vs Year 3/4 Investor.

But this is not the strangest thing about the Presidential Election Cycle anomaly.

Effect of the US Presidential Election Cycle on Foreign Stock Markets

Surely the most striking fact about this quintessentially American calendar anomaly is… that it is not limited to the U.S. stock markets. Stock returns from Europe to Australia to Japan all show the same pattern –they synchronize with the down-then-up cycle of the American presidential calendar, with losses in Year 2 and strong outperformance in Years 3 and 4 of the American Presidential term.

Influence of the US Election Cycle on Foreign Equity Markets
Source: Influence of the US Election Cycle on Foreign Equity Markets.

Explanations – Why Would the US Cycle So Affect Foreign Markets?

Why should this be? Japan, France, Germany, the UK – are all major economies in their own right. They have their own currencies, their own fiscal and monetary policies. Lately, they don’t have such a high opinion of the U.S. it seems. So why should stock markets in Germany, say, track the same spectacular returns in Year 3 of the American electoral calendar? The German electoral schedule is uncorrelated with ours. The political systems in these countries are all quite different from the American electoral system (most follow a parliamentary model). Yet in all 18 countries studied, the U.S. cycle was clearly reproduced, apparently even overriding local political trends.

The “Global Risk Premium”

Some academics have suggested that “the outcome of the U.S. presidential election is a signal about the level of global risk aversion.” Or to put it in English – the U.S. election somehow registers investor sentiment and the outlook for global economic performance, which determines how frisky investors will be in Berlin or Tokyo…

But this “explanation” doesn’t account for the cycle itself. The outcomes do not depend, on average, on which party assumes power, whether there is a change of parties, or what the policy platforms of the candidates are. It is a regular two Flat/Down-Years, followed by two Up-Years. It happens whether the President is a Democrat or a Republican, whether the election is a landslide win or cliff-hanger, whether the economy is in recession or not. Why should all major economies suddenly shift from depressed spirits in Year 2 to party-time in Year 3 of the U.S. cycle? Especially since the studies show that the cycle is not related to American fiscal or monetary policy moves. It seems rather contrived to view the American election calendar as simply some sort of planetary heartbeat pumping or withdrawing “risk” from the world’s markets.

The Penumbra of Empire

A simpler explanation (though less palatable to some) is more likely. The U.S. is (still) the pre-eminent power in global Finance. The U.S. market is worth almost 40% more than all the rest of the world’s major stock markets combined. The dollar is still far and away the dominant reserve currency. Global business runs mostly through American-controlled financial channels. Even China’s vaunted Belt & Road Initiative is financed in U.S. dollars.

Global Stock Market Capitalizations
Source:Global Stock Market Capitalizations.
Reserve Currency Market Share
Source: Reserve Currency Market Share.

Coming out of the latest financial turmoil this year, the Federal Reserve is now widely acknowledged as the de facto Central Bank for the entire world. It backstops the monetary policy regimes of Japan, Europe, and the UK, among many others.

These are just a few of the many ways in which the U.S. completely dominates the world’s financial system.

Maybe it is that simple. In Finance, the U.S. leads and the rest, for now, follow. When a strong cycle moves through the U.S. financial system, as it does with the Presidential electoral calendar, the effects radiate out through the other markets, which are linked to and in many respects dependent upon the global financial center.

Perhaps in decades to come, this relationship will evolve into a more multi-polar system, and this transmission will diminish. But for now the influence of the American superpower prevails in financial markets and that includes its quirks and anomalies.

Author: George Calhoun, Founder & Director of the Quantitative Finance Program and Hanlon Financial Systems Center at the Stevens Institute of Technology (New Jersey) and Advisory Board Member at Hanlon Investment Management.
Editor’s Note: The article reflects the author’s opinion only, and not necessarily the views of the editorial opinion of Belt & Road News.