Is a New U.S. President Good or Bad for Stocks?

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Every financial analyst worth their subscription to The Economist magazine is commenting on whether the economy and business will be better or worse with Obama sitting in the oval office. As we near the inauguration I have received a number of increasingly urgent email questions from readers about the take on the whole thing.

No one can predict the future but there are some very consistent statistics about presidential terms that may help us make some estimates about the next 4 years. What we found is that it really doesn’t matter who the president is but that it is someone new and that the cycle of presidential life has begun again.

[VIDEO] Is a New U.S. President Good or Bad for Stocks?

There is a lot written about stock market cycles. Most of these cycles are based on so little data it is impossible to take them seriously. There are, however, two interesting exceptions and one of these is the “presidential stock market cycle.” Statistically, over many administrations, an unusual pattern has emerged. The first year of a president’s term is a bad one, the second is little better, the third blows the doors off, and the fourth reverts back to mediocrity.

Year 1: Average gain of 4%

Year 2: Average gain of 6%

Year 3: Average gain of 18%

Year 4: Average gain of 10%

In the study we used a mix of small and mid-cap stocks but the pattern holds true whether you only use small caps or even large caps. Why should this be and what should we do about it?

One of the theories about this phenomenon (that I subscribe to personally) is that the first year is the year that the new administration tries to deliver on a bunch of promises by doing a lot of “stuff.” Traders are fond of saying that there is no such thing as a bad market, only bad policies. That would certainly explain the issues that we see in the first year of a presidency.

The excess governmental activity in the first year creates a lot of uncertainty, which is not usually good for stocks. By the time the third year comes around, the administration is typically “retrenching” and trying not to mess up too much before they have to run for office again. That slow-down in activity may remove some of the uncertainty in the market, which could be one explanation for the boost in the third year.

Assume with me that you believe the presidential cycle has some statistical validity and that 2009 is likely to be a rough one regardless of who wins. Are there ways to control your risk? Yes there are. For example, assume that you are a small cap stock investor (aggressive and risk tolerant) but you want to provide a small hedge for yourself against a decline next year without eliminating the possibility of some profits. Covered calls on a small cap ETF may be just the solution.

In the video, I will show you how a covered call with an expiration of January 2010 can provide a hedge of 10% of the total value of the ETF while still providing the opportunity for 20% maximum profit, should the market rally. A covered call is great for traders who don’t want to exit the market but want to hedge some of the risk. In some cases, this potential return could be much higher if you sold the covered calls on a month to month basis over the next year.

In my opinion, it is far more effective to do something about the risk that you can control than worry and speculate about something you can’t control. The actions of the new president are not up to you individually and the vague plans put out by the new chief to address the current crisis and economic slow-down are no better than random variables anyway. It probably doesn’t matter what the new president does; what does matter is what you do about it.

Author’s Note: This video was originally shot in November 2008 before the election.