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President Cycle and Stock Market Performance

September 8, 2008 / 2 Comments on President Cycle and Stock Market Performance

Contrary to the common belief that Republican presidents are good for the stock market, there is really not much evidence to it.  Jason Zweig of WSJ tells you why and suggests you don't put real money betting on it, even on Democrats.
 

If You Bet on the Election,
Don't Use Real Money

Theories about Picking Stocks
Based on the "Presidential Cycle"
Don't Hold Up to Scrutiny

Every four years, as the clatter of the presidential campaign reaches a crescendo, Wall Street adds its voice to the din. Financial pundits spew forth one nostrum after another, often contradictory, never documented with evidence and always tailor-made to spur investors into making more trades. If you haven't yet heard "The stock market prefers Republicans," you will soon hear "The stock market prefers Democrats" or "Gridlock is good for investors."

Now that we know it's McCain and Palin against Obama and Biden, let me tell you three things about the "presidential cycle" in stock returns. There's not much to it, most of what you hear about it is wrong and there's no reliable way to make money on it.

From 1926 through the end of August, according to data from the market researchers at Ibbotson Associates in Chicago, the Standard & Poor's 500-stock index has done distinctly better under Democratic presidents (9.2% annually after inflation) than under Republicans (4.6%). While large stocks fared well in Democratic administrations, small stocks have skyrocketed, returning 16.5% a year after inflation, versus just 2.2% annually under Republicans. On the other hand, bonds have done much better in Republican than Democratic administrations (4.8% versus negative 0.4% annually, after inflation).

[Intelligent Investor]
Heath Hinegardner

Why do stocks do better under Democratic presidents? Robert Johnson, a former finance professor who now helps run the CFA Institute (which trains financial analysts world-wide), has studied the phenomenon and found an explanation that has nothing do with party. In years when the Fed tightens the money supply by raising interest rates, the market does poorly; when the Fed eases by cutting rates, the market does well. Rate cuts are most common in the third year of presidential administration — helping explain why stocks have a significant tendency to do roughly twice as well in Year 3 of presidential terms as in years 1, 2 or 4.

Once you account for the market impact of the Fed's actions, the apparent predictive power of the presidential cycle evaporates; if you don't know whether the Fed will have to raise or lower interest rates, it doesn't matter which party is in power.

What about the nearly universal belief that "gridlock is good"?

Some pundits base that claim on numbers dating back to 1901. Dig into the data, however, and you discover that the gains from gridlock come entirely from a single year: 1919, when Woodrow Wilson, a Democrat, had to cope with a Republican House and Senate (and his own failing health). But it's absurd to give gridlock the credit for the Dow's 30.5% rise that year. Instead, it was the end of World War I, in the final weeks of 1918, that propelled the market to one of its best years ever.

The Stock Trader's Almanac, a popular reference book on Wall Street, reports that since 1949, the Dow has gone up by an annual average of 19.5% when the White House was Democratic and Congress was Republican. But that form of gridlock has occurred in just six of those 60 years, all under Bill Clinton, and in only 10 years in the past century. Such a thin slice of history is no basis for an investing strategy.

Overall, gridlock isn't good for investors. Since 1926, the S&P 500 has gained an average of 6.3%, after inflation, whenever one party controlled the White House and the other held the majority in both houses of Congress. That's less than the 6.8% annual average for the period as a whole.

What, then, should you do? The big margin of outperformance by small stocks under Democratic administrations might be worth betting on if you think Obama will win. But I wouldn't bet big on small-caps; they've beaten large stocks by such a wide margin lately that they are hardly a steal.

This time around, the credit crisis has made banks so reluctant to lend and borrowers so shaky that the Fed's recent rate-cutting push has hit the economy with all the impact of a piece of overcooked fettuccine. If the Fed has been rendered at least temporarily ineffectual, whoever is elected president may be forced to boost government spending in order to kick-start the economy. About all we can confidently say, then, is that this is unlikely to be a good time to add a lot of bonds to your portfolio.

Sometimes the most important thing for an investor to know is what not to do. Vote with your ballot; do not vote with your portfolio.

 

Compare America and Japan: the lessons from "lost decade"

September 5, 2008 / 1 Comment on Compare America and Japan: the lessons from "lost decade"

America had a bigger housing bubble than Japan, but will American be able to avoid the "lost decade"? From Economist:
 

Lessons from a “lost decade”:

Will America follow Japan into a decade of stagnation?

AS FALLING house prices and tightening credit squeeze America’s economy, some worry that the country may suffer a decade of stagnation, as Japan did after its bubble burst in the early 1990s. Japan’s property bubble was also fuelled by cheap money and financial liberalisation and—just as in America—most people assumed that property prices could not fall nationally. When they did, borrowers defaulted and banks cut their lending. The result was a decade with average growth of less than 1%.

Most dismiss the idea that America could suffer the same fate as Japan, but some of the differences are overstated. For example, some claim that Japan’s bubble was much bigger than America’s. Yet average house prices nationwide rose by 90% in America between 2000 and 2006, compared with a gain of 51% in Japan between 1985 and early 1991, when Japanese home prices peaked (see left-hand chart). Prices in Japan’s biggest cities rose faster, but nationwide figures matter more when gauging the impact on the economy. Japanese home prices have since fallen by just over 40%. American prices are already down by 20%, and many economists reckon they could fall by another 10% or more.

What about commercial property? Again, average prices rose by less in Japan (80%) than in America (90%) over those same periods. Thus Japan’s property boom was, if anything, smaller than America’s. Japan also had a stockmarket bubble, which burst a year earlier than that in property. This hurt banks, because they counted part of their equity holdings in other firms as capital. But its impact on households was modest, because only 30% of the population held shares, compared with over half of Americans.

Nor were Japanese policymakers any slower than American ones to cut interest rates and loosen fiscal policy after the bubble burst, contrary to popular misconceptions. The Bank of Japan (BoJ) began to lower interest rates in July 1991, soon after property prices began to decline. The discount rate was cut from 6% to 1.75% by the end of 1993. Two years after American house prices started to slide, the Fed funds rate has fallen from 5.25% to 2% (see right-hand chart). A study by America’s Federal Reserve concluded that Japanese interest rates fell more sharply in the early 1990s than required by the “Taylor rule”, which establishes the appropriate rate using the amount of spare capacity and inflation.

Japan also gave its economy a big fiscal boost. The cyclically adjusted budget deficit (which excludes the automatic impact of slower growth on tax revenues) increased by an annual average of 1.8% of GDP in 1992 and 1993—similar to America’s budget boost this year. Japan’s monetary and fiscal stimulus did help to lift the economy. After a recession in 1993-94, GDP was growing at an annual rate of around 2.5% by 1995. But deflation also emerged that year, pushing up real interest rates and increasing the real burden of debt. It was from here on that Japan made its biggest policy mistakes. In 1997 the government raised its consumption tax to try to slim its budget deficit. And with interest rates close to zero, the BoJ insisted that there was nothing more it could do. Only much later did it start to print lots of money.

America’s inflation rate of above 5% is an advantage. Not only are real interest rates negative, but inflation is also helping to bring the housing market back to fair value with a smaller fall in prices than otherwise. But in another way America is more exposed than Japan was. When its bubble burst in 1991, Japan’s households saved 15% of their income. By 2001 saving had fallen to 5%, which helped to prop up consumer spending. America’s saving rate of close to zero leaves no such cushion.

The perils of procrastination

John Makin, at the American Enterprise Institute, a think-tank, argues that monetary and fiscal relief were necessary but not sufficient to revive Japan’s economy. The missing ingredient was a clean-up of the banking system, on which Japanese firms were more dependent than their American counterparts. Japanese banks hid their bad loans beneath opaque corporate structures, and curtailed new lending to profitable businesses. A vicious circle developed, whereby banks’ bad loans depressed growth which then created more bad loans.

In another new report Richard Jerram, at Macquarie Securities, concludes that America “will not come close to repeating the experience of Japan”, because its regulatory system, financial markets and political structure will not let it procrastinate for so long. America has a more transparent regulatory structure which presses banks into recognising losses and repairing their balance-sheets—even if regulators were slow to recognise that the banks were shifting risky securitised assets off their balance-sheets in the first place. But Japan’s regulators for a long while were in cahoots with banks over hiding their bad loans.

Over the past year, American banks have been quicker than those in Japan in the 1990s to disclose and write off losses and raise new capital. In Japan it took a long while before the political will was there to use taxpayers’ money to plug the banking system. A big test for America’s Treasury will be how quickly it recognises the need to nationalise Fannie Mae and Freddie Mac, the teetering mortgage giants.

One advantage over Japan, says Mr Jerram, is that America is spreading the costs of its housing bust across other countries. Foreigners hold a large slice of American mortgage-backed securities. Sovereign-wealth funds have provided new capital for American banks. And America’s booming exports have helped to support its economy, thanks to the cheap dollar. In contrast, the yen’s sharp appreciation after Japan’s bubble burst hurt exports at the same time as domestic demand was being squeezed.

By learning from Japan’s mistakes, America can avoid a dismal decade. However, it would be arrogant for those in Washington, DC, to assume that Japan’s troubles simply reflected its macroeconomic incompetence. Experience in other countries shows that serious asset-price busts often lead to economic downturns lasting several years. Only a wild optimist would believe that the worst is over in America.

Roach: Beijing’s New Olympian Task

September 5, 2008 / Leave a comment

Stephen Roach, Morgan Stanley Chairman in Asia, wrote on FT that Beijing's biggest task, call it new Olympian task, is to fight inflation. He rebukes the notion that China's inflation is due to structural change thus monetary policy has no role in it.
 

Beijing’s Olympian task is to curb inflation

By Stephen Roach

Too much is being made of the economic impact of the Beijing Olympics on China and the rest of Asia. China was slowing before the onset of the XXIX Olympiad and is likely to continue to slow in the year ahead. Elsewhere in Asia, a similar outcome appears to be in the offing.

Significantly, most of the Olympics-related construction activity in Beijing – some $42bn (€29bn, £23.6bn), according to the official Chinese tally – was completed more than a year ago. That means any post-Olympics construction payback should have occurred quite some time ago rather than in the aftermath of the summer games. Yes, there were plant closings in Beijing and the neighbouring city of Tianjin for a few weeks before and during the Olympics. But these two metropolitan areas collect­ively account for less than 6 per cent of total Chinese output – hardly enough to make much of a dent in the Chinese production juggernaut.

At work, instead, are powerful repercussions of an external shock that has nothing to do with the Olympics: post-bubble adjustments bearing down on the US consumer, along with collateral damage now starting to show up in Europe and Japan. Developing Asia is the most export-intensive region of the world, with a record of more than 45 per cent of its pan-regional output now going to foreign markets. China’s export share is close to 40 per cent. As the industrial world slows, China and the rest of export-dependent developing Asia will feel the effects of a shortfall in external demand with a lag. Any gyrations traceable to the Olympics are likely to be overwhelmed by these much broader, more powerful macro forces bearing down on the region.

Policymakers in China are very much aware of the mounting downside risks to economic growth. Bank lending quotas, which have been the centrepiece of recent tightening initiatives, have now been relaxed. The pace of currency appreciation has also slowed – a sharp departure from the accelerated rate of revaluation that had been evident in late 2007 and early 2008. And policy interest rates have been left unchanged in a rising inflationary climate – keeping real short-term interest rates close to zero, a highly stimulative position for any country’s monetary policy. In short, China’s pro-growth policy bias is once again coming though loud and clear, reflecting a shift in its policy stance that seems traceable to events far bigger than the ­Olympics.

In this context, inflation remains the biggest riddle for China. The recent pro-growth policy initiatives suggest that Chinese authorities are attempting to put a floor on the gross domestic product growth shortfall of somewhere in the 8 to 9 per cent range. Perhaps the biggest macro question for China over the next year is whether such a slowing – from the torrid growth pace of nearly 12 per cent in 2006-07 – is sufficient to stem the recent build-up of inflationary pressures.

There is good reason to believe that inflation risks will remain China’s most daunting macro challenge over the next few years. Particularly worrying is a growing inclination of Chinese officialdom to dismiss the build-up of inflationary pressures as “structural” – traceable to special forces that are argued to be beyond the control of domestic monetary policy. Three such developments are cited most frequently: recent labour reforms that have boosted minimum wages, an outbreak of “imported” commodity inflation, and international price equalisation that is presumed to bring the quotes of Chinese products up to world standards.

This structural excuse for China’s inflation problem is painfully reminiscent of an equally erroneous dismissal of US inflation risks in the 1970s. Back then, three structural forces were also cited as being beyond the purview of the US Federal Reserve, namely wage indexation to CPI shocks that created a wage-price spiral, imported inflation due to the worldwide commodity boom of the early 1970s, and mandated increases in production expenses traceable to regulatory initiatives in pollution abatement and worker safety.

The most important lesson of the 1970s is that the Fed proved to be dead wrong in dismissing inflation risks as structural. While inflation eased off in the middle of the decade as the US went through a deep recession, it roared back with a vengeance as the economy recovered in the latter half of the 1970s, hitting a high of 13 per cent by the end of 1979. It took a new, courageous Fed chairman, Paul Volcker, to put the structuralist inflation argument to rest by driving up the federal funds rate to extraordinary levels and putting the economy through a wrenching hard landing.

That is an outcome that China – and an increasingly China-centric developing Asia, long fixated on social stability and poverty reduction – simply cannot risk. A hard landing could prove devastating to regional development imperatives. Yet to the extent that China and other Asian countries dismiss mounting inflation risks as structural and fail to heed the most salient lesson of the 1970s, the risk of an eventual hard landing will only grow.

That poses a serious question for the rest of Asia as well as for the broader global economy: can a build-up of inflationary pressures be contained to China? In the near term the downside of the global business cycle may limit the spread of inflation. But over the medium term that could change. The cross-border linkages of globalisation may make containment of Chinese inflation exceedingly difficult.

Temporary growth risks should not be the dominant concern in post-Olympics China. Stagflation may well be the greatest risk: an externally induced growth shortfall coupled with a significant deterioration of underlying inflation risks. Chinese officials are fixated on the growth side of the stagflationary equation, but they ignore the inflation piece of the outcome. That remains the greatest worry in the aftermath of an otherwise spectacular Olympics.

 

Misery Index by President

September 5, 2008 / Leave a comment

Misery index = unemployment rate + inflation rate

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