Market Outlook – March 3, 2004(A)

At the beginning of 2003 we argued for a stock market recovery based in part on what is known as “the presidential cycle.” We noted that since the inception of the S&P 500 in 1926 the market had declined only once in the third year of a presidential term. (Even then the decline was less than 1%.) As 2004 unfolds it is natural, then, to ask what history has to say about the stock market in election years.
Since 1926 the stock market has declined in only three of 19 election years: once as the Great Depression bottomed in 1932; once as World War II began in 1940; and once in 2000 when the tech bubble burst (data courtesy of Ken Fisher in Forbes). From this we gather that it takes a lot to derail the market when presidential elections are at stake.
And, indeed, the political forces that give rise to these market regularities are once again at work. With the Federal Reserve holding interest rates at multi-decade lows and roughly $40 billion of tax refunds about to wash across the electorate, the prevailing winds are quite positive for both the economy and the stock market. Capital spending—long a missing link in the recovery—kicked in decisively during the final quarter of ’03 as corporations gained confidence in the current economic expansion.
That same confidence has started to show up in hiring as the manufacturing sector stopped shedding jobs in February after 43 straight months of job losses. No doubt President Bush wishes for something more robust on the employment front but from a purely economic perspective things do not appear particularly dire.
The fact is the last recession began from an abnormally low level of unemployment—3.8%. That level was reached the same way we got to 5000 on the NASDAQ and $81 a share in Lucent: namely, through an overinvestment in productive capacity that eventually collapsed under its own weight. Too many routers connecting too much fiber-optic cable installed by too many people was the cause of the last recession. A return to such extremes isn’t likely, but neither is it necessary to sustain the current economic expansion.
Indeed, the economy overall is hitting its sweet spot right on schedule as the election season gets underway. Low rates, deficit spending, tax cuts and a soft dollar are working their magic but not yet threatening to overdo the job. Thus we expect election year 2004 to smile on the stock market, if less brilliantly than did 2003.
The real question marks come in 2005. History shows that whoever is elected will choose the first year of his new term to get unpleasantries out of the way. Since 1926 the market has declined in 10 of the 19 first years of presidential terms. In the present case, Bush would likely cut Federal spending as budget hawks try to rein in the expense side of the Federal Budget. Kerry, working on the income side, would try to rescind some of the Bush tax breaks for the wealthy. Either way, Greenspan’s “considerable period” for holding down interest rates will likely expire shortly after the polling booths close on the evening of November 2. Each of these scenarios poses a potential problem for the stock market in 2005.
We take these risks seriously, but we’re hardly alone in doing so. Indeed, the consensus on Wall Street is for trouble in 2005. As consensus opinion has a way being wrong, we’re keeping an open, contrarian mind for possible upside surprises. A synchronized expansion in China, Japan, Europe and the US would fill the bill quite nicely.