As America heads to the polls today, you will of course be seeing no forecast from The Value Perspective as to who the 45th President of the United States will be. As we have argued many times before, most recently in Brexit’s double illustration, no expert can predict the future – and, as we shall see, that includes no expert being able to predict when another expert is going to change their mind about predicting the future.
When the highly regarded Financial Times columnist John Authers decided to write a piece last month entitled How it pays for investors to get timing right on US presidents, he presumably thought he was on safe ground referring to a relatively well-known piece of investment thinking – that returns from US equities have tended to be at their strongest in the third year of a US president’s four-year term.
The man behind this idea is GMO co-founder Jeremy Grantham, an investor for whom we have a great deal of respect here on The Value Perspective. His number-crunching of US markets going back to 1932, found that returns from equities in the third year of a presidential cycle averaged more than the years one, two and four put together.
Nobody ever really argued the research was not based on a smallish sample size – kicking in midway during Herbert Hoover’s time in office, even now it covers just 21.5 four-year presidential terms and 13.5 presidents. Still, there does appear to be a plausible sort of rationale underpinning the whole idea – providing one sets aside questions of valuation. Just for a moment, of course.
After all, presidents are likely to enact their most controversial reforms in the early years of their time in office, when they enjoy the most political capital. The third year thus becomes what Grantham characterised as the “sweet spot”, when the advantages of those early reforms are hopefully being reaped but before the uncertainty of the next presidential campaign starts to take hold.
“As the dates of US elections are fixed in the constitution,” writes Authers, “the entire cycle is readily predictable” – a word that, despite all our warnings, is always going to have a lot of investors pricking up their ears. He then goes on to consider other similar theories on the US market, including the implications of a president controlling Congress or not and indeed of their being Democrat or Republican.
Change of tack
Towards the end of his piece, however, Authers changes tack slightly and, having asked what factor matters most when it comes to the fortunes of investment markets, he concludes it is not presidents but central bankers. “Market analysts spend so much time trying to predict what the Fed will do next for a reason,” he explains. “Control over the price of money is all-important.
“A tightening of interest rates, or a signal from the Fed that it is considering it, means that inflationary pressures are rising, and means investors should shift towards assets that shield them from inflation. Of course, presidents and Congress do get to choose the Fed’s governors, but are not able to interfere with the central bank.”
Now, clearly you do not get to be the senior investment commentator on the Financial Times for nothing and it turns out Authers had been very prescient ending a piece on using presidential terms to time the market with a conclusion that did not have all that much to do with presidential terms. Because guess who had just come to the conclusion that Grantham’s ‘presidential cycle’ theory no longer held true?
That’s right – the man himself. So just 24 hours after Authers’ first piece, the FT was publishing a second column, this time outlining how Grantham now believes the Fed has “killed off” a cycle, for which it was actually responsible. What is more, there does appear to be a plausible sort of rationale underpinning the whole idea – providing one sets aside questions of valuation. Just for a moment, of course.
“The presidential cycle owed everything to the Fed,” Grantham told the FT. “The Federal Reserve, completely innocently, always decided to come to the aid of the party in power.” As Authers explains: “This involved stimulating the economy in the third year of the term, so that the economic benefits would be feeding through as voters went to the polls in the fourth year.
“As stockmarkets attempt to pre-empt economic developments, the effect on share prices was felt in year three. They did not stimulate earlier in the cycle ‘or everyone would have forgotten about them by year four’.” Whether or not you are convinced by that argument – or indeed the earlier one – an awful lot of commentators were using Grantham’s theory to predict a bumper year for US equities in 2015.
This did not materialise, however, as it also failed to in 2011 – year three of Barack Obama’s first term in office. Grantham now pointed out to the FT such predictions – and indeed his own 2014 warning of a “speculative bubble” in the asset class the following year came before “the age when the Fed became the dominant force in economics and finance and assumed enormous power”.
He added: “They are constantly looking for excuses to push down on interest rates and drive asset prices higher to get some wealth effect. I don’t trust them any more to play the easy presidential cycle.” As the FT points out, the third and seventh years of President Obama’s administration were actually the only two years of his time in office when the S&P 500 index failed to rise.
Mitigating factors suggested for 2011, when the market index finished where it started, included the eurozone crisis, the negotiations over whether the US would breach its debt ceiling, and the Standard & Poor’s downgrade of US sovereign bonds. Last year, adds the FT, was affected by the Fed as it “stopped buying securities to support the market at the beginning of the year and raised target rates in December”.
Grantham concludes by pointing out to Authers how the “more aggressive policy” of former Fed chairman Alan Greenspan changed things for those who followed him, adding: “They didn’t get the principle that you are meant to pull back in years one and two and wait until year three. Greenspan stimulated in years one and two as well.”
Now clearly, here on The Value Perspective, we would not dream of taking issue too strongly with someone of Grantham’s stature but it is not unfair to suggest this is another example of an investment theory working very well right up to the moment it doesn’t. Investment markets offer countless variables from which people can – and do – seek to draw meaningful correlations.
Sometimes these correlations look strong enough to encourage investors to think they can ‘time’ the market though two facts may serve to dissuade many from trying. One is that someone who remained invested in a basket of global equities from 2005 to 2015 would have seen a return of around 60% yet, if they had somehow contrived to miss just the 10 best days, they would have ended up with a 5% loss.
Furthermore, an investment in the S&P 500 between 1927 and 2014, would have produced a positive return in 88% of all five-year periods, in 94% of all 10-year periods and in 100% of all 20-year periods. If you still feel like trying to time the market, by all means try but history suggests that if a pesky central banker does not derail your investment strategy, some other factor will.
Of course, although past performance should not be used as a guide to future performance as it may not be repeated, the one investment strategy that has yet to be derailed over its more than a century of existence and brooks no if, buts or other caveats – aside perhaps from the injunction to stick with it for at least five years and preferably more – is value. Investors who buy lowly-valued business with strong balance sheets and little debt should not have to worry about booms and busts, Democrats or Republicans, presidents or elections.
Yes, even this time.
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