What Do You Do, Mr. Number Two?

Ever wake up and recall the most bizarre dream during the night without remembering a single detail about it?  It makes for a weird start to the week, particularly when you have a strange feeling that it may have involved Mr. Number Two.

Number Two

Coincidentally, “Mr. Number Two” may hold some significance for investors these days.  We’ve published our thoughts on the Presidential Cycle in the past.  Most notably, in our Q3-10 Broyhill Letter, we speculated that “a classic Third Year Rally may well be the ace in the hole for risk assets over the next twelve months.”  The reason is unmistakably simple. Presidents really like being re-elected and a really accommodative Fed in Year Three can do wonders for an incumbent’s odds. Jeremy Grantham best described this suspicious behavior in GMO’s April 2008 letter to investors:

“Changes in employment in years three and four appear to have the most effect on votes . . . We found that it is hard to find factors in the financial system such as money supply or interest rate changes that are big enough to cause the observed market effect. We concluded that it is likely that it is the whole financial package topped off and dominated by moral hazard that is the key factor: the unspoken promise is that if you speculate in years three and four and things go badly you are likely to receive help because the Administration and its typically co-operative Fed hate things to go badly wrong as the election nears. (Don’t judge Fed co-operation by what is said, by the way, but by the strength of the market effect.)

“In contrast, in years one or two, when financial conditions are typically tightened, if you speculate and lose you will typically be left on your own to rue the errors of your ways. We found that the year three stimulus effect since 1932 is so profound (plus 22% real return for the S&P 500) with no year worse than -2%, that it could not be luck at the 1 in 10,000 level. Years one and two, in remarkable contrast, return an average of less than 1% real.”

The issue for investors today is that the market has just entered its historically worst twelve-month period for performance – Year Two of The Presidential Cycle.  While most market pundits gravitate towards calendar year performance in examining stock returns, we have found statistically greater significance in analyzing annual periods beginning in October and concluding in September.  The chart below demonstrates this seemingly minor modification, with the impact on Year Two and Three particularly pronounced.

Average Gain

The pattern becomes even more apparent if we split year two of the Presidential Cycle into two periods.  According to William Hester at Hussman Funds, “The average market performance during the period from January through September of each second year of the Presidential Cycle has been roughly flat since 1933. The market has been down during these periods nearly as much as it’s been up.”

Of all the January through September periods since 1933, six of the ten worst performances have occurred in the second year of the Presidential Cycle.  Importantly, valuation mattered in both tails of the distribution, with the most extreme losses coinciding with similar extremes in overvaluationAnd judging by the performance of speculative stocks in Year Two, per the chart below, investors would be well served to stick with quality until Aunt Janet signals the all clear.  While one could certainly make the case for a year-end rally once Washington comes to its senses, it’s important to recognize the difference between speculation and investment.  As Jeremy Grantham first noted in the above-referenced letter, “The trouble with markets is that if you let them get totally out of control, they will likely burst at the most inconvenient of times.”

GMO Cycle