John Maynard Keynes, the architect of the 20th century’s leading economic theory and a top investor, once said, “Successful investing is anticipating the anticipations of others.”

What he meant was, no matter how far-fetched a theory driving investor behavior seems to you, if it’s moving the market, you should use it to your advantage.

Case in point: the presidential election cycle theory.

Will the final stretch of Biden's first term bring a Santa rally?

The presidential election cycle theory posits that the stock market behaves in a predictable manner over the course of a U.S. president’s term in office.

The market does worse in the first two years of the term, when the president is pushing through all his most painful policies and pandering to the special interests that got him elected.

In the third year, the market picks itself back when the president turns his full attention to boosting the economy to get re-elected.

Then the market falls off again in the fourth year as jitters about the election depress returns.

2023 marks the third year of Joe Biden’s presidency. If the theory is right, stock prices should theoretically jump over 16% this year, about 10 percentage points more than its historical average.

history presidential term

The theory was first published by Yale Hirsch, the founder of the Stock Trader’s Almanac. You might know him from such catchphrases as “the Santa Clause rally,” and “Sell in May and go away.”

The theory looks like a winner.

Between 1933—Franklin D. Roosevelt’s (FDR) first year in office—and 2019, the stock market experienced gains in 70% of all calendar years. But during year three of the presidential election cycle, the S&P 500 rose 82% of the time.

Meanwhile, the market rose only 60% of the time in years one and two of the presidencies.

The market’s behavior over this time could not be consistently explained by other economic factors, like the direction or level of interest rates, inflation, or economic output.

That said, there isn't nearly enough data to take these findings seriously. There have only been 15 presidents and 22 four-year terms since FDR took office and restructured the market under his New Deal legislation.

"The slaying of a beautiful hypothesis by an ugly fact”

As Thomas Huxley—aka Darwin's bulldog—famously quipped, great ideas can stumble on harsh realities.

There are many instances where the presidential election cycle theory went awry—in particular after major market dislocations.

First, in the wake of the 1929 market crash, FDR came in swinging, promising to clean up the markets and jump-start the economy.

He passed the 1933 Banking Act, which set up the Securities and Exchange Commission (SEC) and the Federal Deposit Insurance Corporation (FDIC), among other market reforms.

This spurred a relief rally right away. In 1933, the S&P 500 blasted up nearly 47%, more than the— admittedly notable—41.4% rise in his third year.

Another post-crash president, Barack Obama, saw the S&P 500 rocket up 23.5% in 2009, his first year as president. The market’s performance was flat in his third year, in part because of the successful passage of the Dodd-Frank Act, which forced Wall Street to take far less risk.

Also, in both the FDR and Obama cases, the stellar first-year market performance was just a partial rebound from the desperate years that came before.

So, investors didn’t really make money, so much as they scraped their way out of the losses they suffered earlier.

In FDR's case, the S&P had dropped 47% in 1931 and 15% in 1932. In Obama’s case, the S&P had dropped 39% in 2008.

There are also cases where the theory simply failed. For example, during the third year of the inflation-plagued Carter administration, the S&P 500 rose a respectable 12.3%.

But the following year, as Carter got his financial deregulation policies underway, and Fed Chair Paul Volcker got serious about battling 20%+ inflation, the S&P shot up nearly 26%.

Should it be called the “Congressional control cycle theory” instead?

A recent analysis by the CFA Institute suggested that the third-year boom is due to the composition of Congress, not the electoral plotting of the president.

The authors note that a single party held the “trifecta” of the presidency and House and Senate majorities two-thirds of the time in the first and second years of the cycle, but only about one-third of the time in the third and fourth years.

That’s because the parties of presidents in their first terms often face setbacks in the midterm elections.

"Markets may simply be rewarding gridlock,” the study’s authors note. “Third years that followed a switch from unified to split government averaged 15.0% returns compared to 10.7% for third years in which the trifecta was preserved.”

Markets like political gridlock because they hate big fiscal changes, like tax hikes and spending increases.

The CFA Institute warned, though, that even a split Congress can scare the market into underperforming.

The authors wrote, “Total government paralysis and dysfunction — not raising the debt ceiling and not funding the government – may be too much for the markets and economy to bear.”

Weighing fear and greed

The presidential election cycle theory makes a big stock investment this year look like a sure thing.

But, Keynes’ fame aside, many investors today prefer to emulate Warren Buffett, who likes to say you should be “fearful when others are greedy.”

Caution is indeed warranted. If the driving factor is a hamstrung Congress rather than presidential election-year tactics, things aren’t particularly looking up.

The country has had a divided Congress for President Biden’s whole term, and managed to bloat the budget and embroil itself in another debt-ceiling crisis nonetheless.

So, with apologies to FDR, investors might find there are more things to fear than fear itself.