American elections are dominated by the four year terms of the President and Vice President.  While Congressman serve two year terms, and Senators serve six year terms, it is the four year cycle which sets the tone for initiative.  It so happens that the activities of the major political parties and the incumbent President affect the stock market and this week’s subject is about that relationship.

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Market observers have noticed that the stock market tends to do best when the house and/or Senate are controlled by one party, and the Executive office is held by a member of the opposite party.  Apparently, when Washington is in gridlock with one branch acting as a check and balance to the other, things are less likely to get out of hand.  When the same party controls both the executive branch and Congress, spending tends to run amuck and the stock market usually performs poorly.

With the Democrats in control of the House, the Senate, and Obama’s executive branch, we could predict that the market will find it difficult to move forward in the next two years.  It is clear that spending is greater than at any other time in U.S. history and that won’t bode well over time.

We actually didn’t want to focus on the aspect of who controls that various branches of government in the U.S. but rather wanted to focus on what happens during the four year cycle of a U.S. President’s term in office.

When the President takes office, the President needs to follow-up on Campaign promises and pushes to accomplish the major goals of their presidency.  The first year is about gaining momentum on the things that matter to the President and an increase in spending generally accompanies this with rewards dolled out the those that helped the President achieve victory in the elections held in November of the prior year.  Necessarily then, the orgy of spending in the first year isn’t generally perceived to be a positive by market participants and that first year is generally a relatively poor performance year for the market.

The second year of office has more emphasis on seeing the goals through and the funding initiated in the first term is still trickling through much of the budget processes.  Again, the focus is on spending and bending members of Congress to go along with the President’s agenda.  The market tends to see this as a negative as spending remains relatively unconstrained.  This translates to another year of relative underperformance for the stock market.

The third year of office tends to take on an entirely different tone.  For one, another election was held and there are changes in the members of the House and for 1/3rd of the seats in the Senate.  This can change the level of cooperation between Congress and the Executive branch.  It is generally a move toward a bit more gridlock which slows spending.  In addition, the leadership of political parties begin to position for the next four year election.  They realize that voters tend to favor the party that seems like it is being more responsible.  If the economy improves before the election, voters tend to re-elect the incumbent or put into place another member of the same party who rides the coat tails of the sitting President.

This sort of improvement in fiscal restraint and an improved economy takes awhile to get into place so it begins in the third year of the Presidency and market participants notice this.  This results in relative outperformance for the stock market in the third year of a Presidency.

The fourth year is all about getting re-elected or positioning a successor to win the election.  The President shapes policies and reduces spending in a bid to upset as few voters as possible.  In general, the President continues to press for fiscal restraint reducing deficit spending and taking steps to actively improve the U.S. economy.  This results in an outperformance in the fourth year of the Presidency, which is the election year.  Note that late in the year, after the election, the momentum of the upswing that is in place going into November can change, especially if the election results in a future change in party leadership in the executive branch.

What does this mean for the rest of 2009?  This would be the first year in a four year cycle suggesting an underperforming year.  I would argue, however, that with the collapse of the market in 2008, the market could bounce back a fair amount (as it has done).  One must balance a recovery from severely oversold conditions against the Presidential Election Cycle in order to determine what this means for U.S. stock markets.

It seems clear that the reaction of market participants was too negative at the levels reached at the nadirs in the market collapse.  This suggests a recovery from those levels predisposes the markets toward a move higher.  Given that underperformance in year one of the election cycle takes away from the move higher, I would suggest that market participants would do well to temper enthusiasm about market rallies with the reality that regaining too much ground too quickly will likely lead to another correction.  If would further postulate that, if we don’t get a pull-back early in the second half of the year, the likelihood of maintaining or improving from current levels is actually quite low and we could see a collapse late in the year.