You may have heard some people claim there's a reliable, gameable stock market pattern in US presidential terms - that some years are better than others.
You may also have heard that since 1926, every single year ending in five (1935 1945, 1955, etc) has been positive. Every one! But, you've also likely been warned these are silly indicators - as good as voodoo.
The 'year five' quirk is just that - a statistical quirk. There have been eight occurrences out of 10 since 1926. Since stocks rise more than fall, you'd normally expect at least two-thirds of those to be positive anyway.
It's not unreasonable to expect that, with a coin weighted to show heads two-thirds of the time, all eight tosses would be heads. It happens. But it's still just a quirk.
On the other hand, it's a myth that the presidential term is merely voodoo - there are forceful fundamentals that can make the cycle gameable.
It's evident if we analyse presidents, their parties and annual S&P 500 returns, broken into discrete years of their terms (see table, click to enlarge).
It's easy to see that the first two years of each term have worse average returns, with greater return variability.
It's not that years one and two are inherently bad - there can be great first and second years! There's just more variability and some big negatives dragging down the averages.
But the back half is different - average returns are much better, with less return variability.
Year three averages 17.8 per cent without a single negative since 1939. Year four is fine, too, with just slightly more negatives, and 2008's big down year doesn't help the average.
Still, you get more uniformity and better average returns in year four. Is this a quirk? Or real and fundamental?
WHY DOES THIS PATTERN OCCUR?
Patterns happen all the time. That doesn't mean you should make bets on them - unless you can figure whether they are rooted in sound fundamentals, and why.
But there are two basic fundamental reasons behind this pattern. First, investors feel the pain of loss about twice as intensely as the pleasure of gain.
Second, the word 'politics', as you know, derives from the Greek 'poli', meaning many, and 'ticks' meaning small blood-sucking insects.
Although some poli-tics start as normal human beings, they quickly become bloodsuckers with the soul of a tick.
The president, or Head Tic, knows his party will lose relative power to the opposition in the mid-terms, so he knows he must get his most onerous legislation through in the first two years.
Legislation is nothing more than some form of redistribution of wealth. The government takes from one group and gives to another.
Those on the losing end hate losing more than twice as much as the winners like the winning. And those not getting mugged now worry they'll get mugged next.
So political risk aversion rises when the threat of legislation increases in the first two years. It doesn't even have to be passed! Just the threat can roil stocks.
As political risk aversion rises, total risk aversion rises - a negative for capital markets in general.
LAZY LEGISLATORS MEAN HAPPY MARKETS
But in the back half of the Head Tic's term, that changes. The Head Tic's party has already lost relative power to the opposition, so it can't get as much done.
Plus, he starts thinking about re-election himself, or helping the guy from his party get elected next.
Suddenly, politicians yap a lot but do little. People fear getting mugged by the system less, and political risk aversion falls fast - helping stocks.
Landmark legislation tends to pass in the first two years. The third year is best because in year four poli-tics start campaigning again, hinting at all the legislation they'll unleash once elected, and stocks like that less.
But still, they talk and don't do much usually - because they want to avoid annoying valuable swing voters. So fourth years average worse than third years, but are still overall overwhelmingly positive.
But don't just look at the averages; consider what comprises them. Yes, first and second years have poorer average returns. But years that aren't negative can see huge gains!
It's the same fundamental force at work. Legislative risk aversion is typically highest in the first two years, but if that lessens for some reason, that can be a massive positive surprise and boost stocks.
Bear in mind that there are myriad factors acting on stocks, of which political risk aversion is just one. Although the US economy is less than 25 per cent of the whole world, global stocks tend to be positively correlated.
For example, 2009 was President Obama's first year and stocks were up huge, tied to a massive global rally following a steep bear market bottom. That was a huge force driving stocks.
But tied to that, Democrats' newly elected tend to have great first years, which bucks the average but is consistent with what makes up the average.
So always dig deeper into the average. And remember, sometimes apparent voodoo isn't bunk at all.
Ken Fisher is founder and chairman of Fisher Investments.
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