And Now for Some Good News

06/29/2010 3:53 pm EST

Focus: MARKETS

Lawrence McMillan

Founder and President, McMillan Analysis Corporation

Lawrence McMillan, editor of The Option Strategist, says markets tend to bottom in the second year of a US Presidential term.

The Presidential cycle is a seasonal tendency that usually receives a good amount of publicity in the year that it predicts a buy signal. However, this year (which is that year of the buy signal), I haven’t seen any articles on the subject save for the annual mention in The Stock Trader’s Almanac (Jeff & Yale Hirsch, John Wiley & Sons).

Simply stated, the theory is that the market follows a four-year cycle that roughly corresponds to the cycle of US Presidential elections. The technical part of the system is its seasonality, but there are also fundamental reasons why it seems to work. The market usually tops in the year after the Presidential election, as the new President prepares to take on any negative aspects of administering early in his term (the reasoning being that, four years later, most voters will have forgotten the negative things). The market then declines into the second year of his term—the mid-year between elections. Sometime during that year (often, in the fall, and in October, in particular), the market bottoms and then rallies through the third and fourth years, as the economic “pump” is primed in order to make things prosperous for as many as possible prior to the next election.

This is, of course, just a generality, but the cycle has a strong track record, especially the part about bottoming in the mid-year between elections. There is ample evidence of strong market bottoms in the second year. Massive bear markets bottomed in 1970, 1974, and 2002. There were also severe corrections in 1938, 1942, 1946, 1962, 1966, 1978, 1982, 1990, 1994, and 1998 that bottomed in the mid-year and led to very strong rallies.

Most recently, in 2006, there was a sharp correction in May and June (from SPX 1325 to 1220—about 9%). There was great debate after that, as the market rallied into the fall, about whether or not the June bottom was the bottom. It was, but since it didn’t conform to what many had hoped would be an October bottom, the Presidential cycle was discredited in some articles and by some media types.

In reality, the bottoms have come at various points in the year. For the years listed above, the monthly distribution is quite spread out. Counting the double bottoms, only seven [of 18] occurred in the fall of the year. Six occurred in the summer, and the remaining five were between February and May. October and August tied as the most frequent months, albeit at a lowly three times each.

[In] 2010, if the bottom is in, it was just put in, in late May—at about 1040 on the S&P 500. So we certainly haven’t missed it. In years where there was a second decline (1974, 1994, 1998, and 2002), the second decline was more or less a retest of the first decline. In other words, a “W” bottom was eventually formed. So buying near the first bottom wasn’t a major mistake—it was just a little early.

Of course, we have other indicators to rely on as things unfold. In particular, for a bottom of this magnitude, it would be considered at least an intermediate-term buy signal. Thus, we can use the equity-only put-call ratios, market breadth indicators, and the trend of volatility as guides in identifying when the bottom is in. So far, those haven’t turned bullish yet, but such buy signals might not be far away. The fact that they could also be coinciding with the powerful Presidential cycle makes me think that the next set of buy signals should be heavily respected when they occur.

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