Feb 08, 2011

One Unblemished Indicator’s Surprising Results

By Andrew Mickey, Q1 Publishing

Stock market forecasters have latched onto a lot of “indicators” over the years, but most are completely worthless.

For example, timely “Super Bowl Indicator” has many in the financial community as excited as Packers fans.

The Super Bowl Indicator states stocks go up when one of the original NFL teams (the teams before the merger with AFL) win the championship. This indicator has been “right” 35 out of the first 44 years. The Packers are one of those original NFL teams.

Another popular indicator, the “January Barometer,” states stocks continue to rise for the rest of the years after posting gains in the month of January. For 50 years stocks increased an average of 7.7% following a good January. The S&P 500 was up last month.

However, these “indicators” are complete nonsense. The Super Bowl Indicator is nothing more than pure coincidence. And the January Barometer is based on a random market move over an arbitrary – and short - time period.

As an example of how arbitrary these indicators are, another indicator says stocks are going down this year. A few minutes of fun-with-spreadsheets has found that the S&P 500 increases 1.9% in years in which your editor’s age is a prime number. On the other hand, the S&P 500 has increased by an average of 11% per year when my age is a composite number.

These indicators are tragically flawed and baseless. But there’s one that is not. And now that the market has posted an eight week winning streak and, as a result, is positioned for a sharper and more fear-inducing correction, it’s critical to be aware of its remarkably accurate signal.

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A Perfect 70-Year Track Record

The Presidential Cycle Indicator, which states that stocks go up in third year of a presidential term, is one indicator with an exceptional track record and a well-reasoned rationale.

It has proven 100% correct since World War II as well.

Perhaps more importantly, the third year of a presidential term is when stocks do their best.

Stocks have gone up an average of 13% during the third year of a presidential term since 1928. Returns in those years have been so strong that they accounted for more gains than the first, second, and fourth years put together.

There are many reasons for this. The regulatory environment in the third year of a president’s is fairly static. Most of the political capital from the president’s election has been spent on new laws, regulations, and/or tax cuts much earlier on and the markets are incorporating them all.

Also, the last couple years of a presidential term are no times for tough decisions. We’re seeing this right now. The tough decisions on how to reduce the deficit have been largely punted to 2013.

The stable environment has led to a situation where more than 60% of GDP growth comes in the last two years of a president’s term. In theory, stocks will anticipate that additional growth.

Right now we’re in the third year of the presidential term which has historically been great for stocks and the economy. But there’s another well-founded indicator that just adds to the reasons for 2011 to be another good year for stocks.

Gridlock is Good

There’s a long-running correlation between which political parties and stock market performance.

Conventional wisdom would say that the traditionally pro-business, low-tax Republicans in control would be good for stocks and the traditionally high-tax, pro-union Democrats would be a drag on stocks.

Conventional wisdom, as usual, is wrong in every way.

The table below breaks down stock market performance relative to each combination of which party, Democrat (D) or Republican (R), controls which Congressional chamber and the presidency:

More than 80 years of history shows that gridlock is good.

Stocks have done best when control of one chamber of Congress and/or the presidency is divided.

Perhaps as evidence of the corruptibility of absolute power, stocks perform worst when one party controls all elected parts of the federal government.

This indicator is one worth your attention for a couple of plausible reasons.

Libertarians can and have made a strong case concluding the less Washington does, the better. And when both parties have to sign off on a bill, much less gets done.

Another likely catalyst for the divergence in stock market returns would relate more to spending and taxes.

When it comes to spending, a politically divided government often results in very costly vote-buying. Only in Washington is there a compromise where both sides get what they want when it comes to spending.

The tax side of things is a bit simpler. With the exception of the far left, no politician hikes taxes before an election.

Regardless of the actual cause for it, history has found gridlock is good for stocks.

A Rough Ride to Go

There’s a lot of evidence stacking up for stocks in 2011.

We’re entering the third year of the presidential election cycle and the Republican-controlled house has put everything in place for two years of relative gridlock.

The one thing these indicators do not tell us is that stocks are going to rise steadily this year.

Stocks have posted alarmingly consistent gains in the first few weeks of the year, but most other indicators signal a correction is nearing.

That’s why these indicators are very important to note right now.

Odds are a correction is coming at some time during the year. In the past two years stocks corrected for times for an average of 13%. A correction is natural and healthy.

Right now, we’re overdue for a correction. And the longer it takes to arrive, the greater it will be. But that’s a good thing for those of us with these indicators in hand because the more panicked the markets will be that the free money, low-interest rate party has finally come to an end, the cheaper we’ll be able to buy back in.

Given that this is the third year of the presidential cycle and the government is politically divided, history would say the correction will be a great opportunity.

Investors should be getting prepared now by identifying great stocks, only buying stocks for specific reasons to not wait for (i.e. special situations), and keep plenty of cash on hand to take full advantage of it.

It won’t be an easy move to make when the correction does come. But it is coming and those of us preparing now will be able to take full advantage of it.

Good Investing,

Andrew Mickey
Chief Investment Strategist, Q1 Publishing

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