Presidential election cycle theory was developed by Yale Hirsch, creator of the Stock Trader’s Almanac. Its premise is that the stock market follows a four-year pattern that corresponds to the four-year presidential election cycle. According to the theory, this is how the market reacts during each year of a presidential term:

Year 1: The first year of a presidency usually sees weak performance in the stock market. Of the four years in a presidential cycle, the first-year performance of the stock market, on average, is the worst.

Year 2: The second year, although better than the first, is also is noted for below-average performance. According to Hirsch, bear market bottoms occur in the second year more often than in any other year.

Year 3: The third year is normally the strongest of the four years.

Year 4: In the fourth year of the presidential term and the election year, the stock market’s performance tends to be above average.

The chart below shows how the Dow Jones Industrial Average (DJIA) has performed on average during the four years of each presidential cycle over the past century-plus.

Below is one more chart to substantiate the validity of the theory. This one shows that the third and fourth years of a president’s term produce market gains more than 80% of the time.

Of course, we are just about finished with the third year of the current presidential term and the market is not going to experience the type of gain illustrated by the first chart. In fact, this could turn out to be one of the 6% of times when the third year of a presidential cycle produces a loss rather than a gain, as shown in the second chart.

The problem with a theory like this is that it is considering the impact of a single factor and then trying to make a forecast based on incomplete data.

Here is a comment from an Investopedia article about the presidential cycle:

“One of the problems with drawing conclusions from the presidential election cycle is that the theory is based on relatively few observations. Since 1900, there have been only 27 presidential cycles to 2008. Many of the studies done on the theory are based on even fewer observations. For example, since 1948 there have been only 15 different terms - when it comes to statistics, this is a very small sample, which makes it difficult to draw accurate conclusions.

“As such, the theory could be attributed to data mining. In other words, if people are constantly looking at enough data for specific patterns, patterns can emerge, even if there is no significance to them.”

The stock market is incredibly complex. Millions of variables, many of which could be unknown and immeasurable, influence it. For well over a century, extremely smart people have devoted enormous amounts of time and money trying to learn to forecast accurately what the financial markets will do next. Yet to date no one has devised a method that is consistently reliable, let alone foolproof.

When it comes to the presidential cycle, there might be some correlation between presidential terms and market behavior. But there certainly is not a cause-and-effect relationship. And 2011 has again proved that just because something happened in the past does not mean it will be repeated in the future.

Have a great holiday season. Our next market update will probably not be until January 6 unless something unusual and unexpected occurs between now and then.

Flint Stephens

After October, I wrote about how the Santa Claus rally came in October this year. I was joking. It isn’t funny anymore.

Since late November, we’ve been anxiously waiting like children on Christmas Eve for the Santa Claus rally to appear and so far we have been disappointed. A few strong positive days after Thanksgiving gave us hope, but they turned out to be the jingle from the neighbor’s doorbell and not the sound of sleigh bells on the roof.

With just a week before Christmas, most major indices are floundering. Fortunately, a slight glimmer of hope remains.

Right now technical indicators for stocks are generally negative. But some are also in areas where turnarounds frequently occur.

Look at the chart below. As you can see, the S&P 500 Index (SPX) has been slipping all of December. The green line is a trendline from the last two major lows. The index is currently resting almost at that trendline.

The next section of the chart is a stochastic oscillator. This indicator is at an unusually low level showing that the index is highly oversold. In most cases when the stochastic oscillator reaches this level a market rebound occurs, as it did at the end of November, the last time it was in this situation.

The bottom portion of the chart is a moving average convergence divergence (MACD). This indicator is right at the zero mark. The encouraging sign is that each of its recent lows has been higher than the previous lows. This is often a good indication that market strength is building and setting up for a stronger and longer rally.

As I wrote about last week, for most of 2011 and sort of a trend has been lacking. There has been plenty of upward and downward volatility, but the most sustained moves either up or down lasted only about eight weeks. That makes it tough for investors and for money managers to make any headway.

Blue chip stocks have fared better in this market than many other issues, which also gives a misleading impression of how the overall equity markets are doing. For example, as I write this the DJIA has a gain of about 2% for 2011. However, the S&P 500 is off about 4% for the year, the NASDAQ is off nearly 6% and the NYSE Composite is down about 10%.

There is still time for a Christmas miracle to occur that would push all of the major stock indices into positive gains for 2011. But it needs to happen quickly.

Negative economic news overwhelmed stock performances for most of the latter portion of this year. Concerns about massive debt loads in Europe and here are foremost on the minds of almost everyone. If the Santa Claus rally doesn’t make its appearance before the end of 2011, all bet are off about how stocks will perform in the early weeks of 2012.

Flint Stephens

I wanted to create a chart that would show in a simple way how investors have fared in 2011. The chart below is what I came up with. The yellow line marks where the S&P 500 began the year. The green portions of the chart mark the periods where the index showed a gain for the year. The red portion of the chart highlights those periods where the index was negative.

What this chart clearly shows is that since the end of July, it has been tough for investors to make money. The year has shown no consistent trend and most moves up or down have been brief and violent. As an example, look at the period from late July to early August when the chart changes from green to red. In about two weeks the S&P 500 went from near the top of its trading range to the bottom.

These sharp whipsaw moves and lack of a sustained trend have created a difficult situation for investors and for professional money managers. According to an article by CNBC this week, “Just one in four managers beat the major stock indexes this year, as an intensely volatile market environment drove an aversion from risk that left many dangerously exposed during pullbacks and woefully flatfooted during rallies.”

An investor who was in or out of stocks or in the wrong stocks for just a few days could easily find himself trailing the index returns by several percentage points.

One of the longstanding rules of investing is to diversify assets to protect against risk. In 2011, however, that strategy failed much of the time. Consider this quote from the same article mentioned above: “The aversion to risk in turn helped drive up correlation—or the tendency of different asset classes as well as individual stocks to move up and down in tandem—making diversification and hedging more difficult and hamstringing returns.”

Given all of the worldwide economic problems and all of this year’s volatility, it is in some ways remarkable for the S&P 500 to be close to the break-even mark at this point in the year. Now major stock market indices have three weeks to decide whether 2011 is going to be a negative or positive year.

Going back to 1988 (23 years) the S&P 500 has ended the calendar year with a loss just five times. Three of those losses were consecutive: -9.1% in 2000, -11.89% in 2001, and -22.1% in 2002. The only other two losing years were 1990 with a loss of 3.1% and 2008 with a loss of 37%. The average annual return of the index over that 23-year period is 10.88%. So ending 2011 in the red would be unusual and significant.

Since 1988, the S&P 500 has ended the year with a gain about 80% of the time. As we have detailed in previous commentaries, there are a host of reasons why it is good for those in power to have the S&P 500 and other major indexes finish in the black. So even though problems in Europe, high unemployment and a growing deficit all currently threaten the U.S. economy, it would be surprising to see a sharp sell off before the end of 2011.  Given current realities, is seems likely that end-of-the-year gains for major indices will be meager. But even a small gain is better than a loss.

Of course, that does not mean that investors can forget about their portfolios right now. Risk remains high and unforeseen events could spark a decline that would make this one of the rare times when the S&P 500 ends a year with a loss.

Flint Stephens

Last week’s commentary explained that in spite of a significant correction in November, investors should watch for a recovery. So far that forecast has been completely accurate.

Wednesday the Dow Jones Industrial Average (DJIA) posted its biggest one-day move since March 23, 2009, and made it back into positive territory for the year. Other major indices like the S&P 500, the NASDAQ and the New York Stock Exchange composite were still in the red for 2011, but they also saw big gains.

The green line on the chart below highlights where the DJIA began 2011. You can see that the DJIA fell below that mark during the August decline and has struggled to make it back to that point until October. The downward move in November seems now to be a fairly typical retracement of the big gains made in October.

For 2011, we are now in the homestretch with just one month left. Wall Street, Congress, the Federal Reserve, and the presidential administration would all like to see major stock indices end the year well into the black. The Christmas shopping season is off to a good start and corporate profits remain strong. Obviously, there are still a lot of economic negatives like the high unemployment rate and the debt troubles in Europe. But don’t be surprised if the problems are pushed aside for a few weeks so that stocks can end the year with a strong rally.

Mutual fund owners need not panic

December can cause needless worry for people who track the daily pricing of mutual funds in their investment accounts. Prices for many funds could experience significant one-day drops this month as yields and dividends on underlying investments within the funds are paid to owners as phantom distributions. For example, in December 2010 the price of Pimco Total Return Fund (PTTRX) dropped more than 5% in a single day. That is a hefty move for a low volatility fund that rarely moves more than a few cents in any session.

In reality, investors who owned the fund on the day of the distribution received a corresponding increase in the number of shares they owned. In other words, while the price per share declined, the total value of an individual investors account remained the same.

In tax deferred qualified accounts like IRAs, 401ks, variable annuities, etc., these phantom distributions have no real impact on an investment portfolio. In non-qualified accounts, however, the IRS views these just like dividends paid by stocks and they are taxable events even though there is no change in the account balance.

Flint Stephens

November’s correction for most major stock indices has been greater than expected, erasing the much of October’s gains. There was a triple whammy for stocks that likely made the correction more serious than it needed to be. First, the European economic problems have traders and investors on edge. Until there is some kind of resolution, market volatility is likely to remain unusually high. Second, this week’s failure of the Congressional super committee to reach an agreement on deficit reductions was a reconfirmation of our own domestic economic troubles. Finally, the uncertainty created by those two situation combined with a holiday break meant that many traders did not want to bear the risk of being long the market over the holiday.

In spite of those challenges, I still expect a rally in stocks and believe that selling right now would be a mistake. Look at the chart below. It shows performance of the Nasdaq Composite over the past year. The gold line is a 50-day moving average (MA) and like this index, most others broke below that MA this week. But the significant portion of the chart is the bottom section. It is a stochastic oscillator and it has fallen to an highly oversold level. Normally when this indicator reaches such an oversold level a market rebound occurs.

After the strong October rally, a November correction was all but assured. But as stocks approach the end of November, the combination of seasonal market strength and oversold conditions should lead to a rally in stock prices.

Of course, there are never any guarantees when it comes to the stock market and more bad news from Europe or home could again overwhelm technical indicators and send stocks even lower. However, the stochastic oscillator tends to be a fairly reliable indicator of a turnaround when it reaches the current level.