Context

Investing without context is like knowing how to drive, but not knowing what the lights at intersections mean.  On the right stretch of road, anyone can cover hundreds of miles without a problem and be confident in their driving skills.  However, intersections are inevitable and without understanding traffic lights, drivers will get blindsided.

As this business cycle turns, I cringe reading articles that say “when the S&P 500 goes down (or up) like this, then that usually happens.”  This is not contextual understanding, but lazy statistical inference.  To illustrate the dangers of this approach, you need to look no further than the articles being published advocating for investing in the stock market during a presidential election year. The basic idea being that presidential elections often bring stimulus or a dovish Fed, which helps stock markets go up.  The data is there to support this hypothesis: on average, investing in the stock market during a presidential election year delivers above average returns.  It’s true.

But life doesn’t happen in averages.  The average driver is not passing through an intersection at any given moment, but survival in a car is about safely navigating intersections.  So think more carefully about these presidential election cycles. If incumbents try to jam the economy upward into an election cycle to get re-elected, wouldn’t the opposite be true for two-term presidents?  In other words, one would think that the end of a two-term presidency should mark the exhaustion of economic policy designed to preserve a legacy, whereas a first-term president would use accelerating economic policy to get re-elected.

Let’s look at the data to test this thought.  What the data shows is that stock market returns at the end of a two-term presidency since 1940 are strongly negative (-8%), whereas returns at the end of a first-term presidency are very positive (10%).  There are more first-term presidents, and so on average, presidential election years have positive returns.  Looking a bit closer, the end of a two-term presidency has marked nearly every significant stock market crash.  And every major stock market crash (but for one) has happened near the end of a two-term presidency.  It seems like you can’t have one without the other.

The list of two-term presidents is below with a brief description of the financial crisis that marked the end of each presidency.  I have included my conclusion on what this history means at the end.  Readers should note that “the Great Depression” in 1929 was the third of its kind in the US and until quite recently -20% declines in prices and economic activity were not uncommon!

Washington (last full year of his presidency was 1796) – “Panic of 1796-1797”, recession from 1796-1799, unwind of a speculative land bubble through deflation imported from England – first major financial crisis in US history.

Jefferson (1808) – “Depression of 1807-1810”, three year recession due to trade embargo with England imposed by Jefferson

Madison (1816) – “1815-1821 Depression”, six year recession as a hangover from excess money printing used to support the War of 1812

Monroe (1824) – “Panic of 1825”, stock market crash in the US and England following speculative excess in investments in Latin America

Jackson (1836) – “Panic of 1837”, Jackson allowed land to be used as collateral at banks creating a boom in money supply, which led to mass bank failures and a depression that stretched from 1836-1843.  America’s first “Great Depression”.

Grant (1876) – Excess money printing from the Civil War and Reconstruction, compounded by railroad strikes in 1877 precipitated stock market declines and a return to the gold standard in 1879 led to America’s second “Great Depression” from 1873-1896.  Economic output declined as much as 30%.

Cleveland (1896) – “Panic of 1896”, the US ran out of gold and had to rely on JP Morgan’s gold reserves in Europe in order to make payments.

Roosevelt (1908) – “Panic of 1907”, largest stock market decline in US history, failure of the Knickerbocker Trust prompted the creation of the Federal Reserve.

Wilson (1920) – “Depression of 1920-1921”, 1920 was the most deflationary year in US history with wholesale price declines of 40% following World War I.

Coolidge (1928) – “Great Depression”, new tariffs in conjunction with an over-levered US export economy shipping to a world with slowing growth drove stock market declines and America’s third “Great Depression”.  Going in to 1929, the US was in a very similar position as China is today.  The US was an export powerhouse that had financed massive productive capacity using debt…and then global growth slowed and our productive capacity was no longer needed until World War II.

Roosevelt (1945) – “Recession of 1945”, post-World War II production declines drove the country into recession.

Eisenhower (1960) – “Recession of 1960-1961”, too early tightening of monetary policy led to a mild recession.

Johnson (1968) – “Recession of 1969-1970”, reduction of budget deficits after Vietnam War spending while the Federal Reserve raised interest rates drove a mild recession.

Reagan (1988) – 1990 recession, record government deficit spending combined with a deregulation of the banking system that prompted speculative lending and precipitated the Savings & Loan crisis.

Clinton (2000) – 2001 recession, speculative excess in the technology sector combined with the collapse of the syndicated loan market due to systemic fraud.

Bush (2008) – $4 trillion growth in the money supply from securitizations unchecked by the Federal Reserve drove speculative bubble in housing that resulted in the Global Financial Crisis.

Obama (2016) – $4 trillion growth in Federal Reserve balance sheet to offset the impact of Global Financial Crisis created excess investment in emerging markets and a wealth effect in the US and Europe that may or may not be sustainable…

Looking historically, it is hard to say that two-term presidents “cause” market crashes.  Many of the examples above are the result of happenstance.  Did Woodrow Wilson’s economic policies cause the recession in the early 1920s?  No.  The end of World War I closed a chapter where the US economy outperformed while European nations were at war.

What one could conclude from our nation’s history is that presidents often win a second term, in part, due to unsustainable economic tailwinds.  These tailwinds rarely last for more than a decade, and so the boost that helps presidents get re-elected often dissipates near the end of their second term.  Just as Wilson enjoyed a boost from World War I, during the Clinton years, the economy happened to benefit from a boost in productivity following decades of investment in information technology.  George W. Bush’s re-election depended on a war economy that was underpinned by an unprecedented expansion of the money supply through the housing market.  Obama would probably not have been re-elected without the wealth effect produced by the Federal Reserve growing its balance sheet with quantitative easing.  Time will tell what the consequences of this balance sheet expansion will be.

THIS ARTICLE REPRESENTS THE VIEWS OF BISHOP ROCK CAPITAL, L.P. AND SHOULD NOT BE CONSIDERED A RECOMMENDATION TO PURCHASE OR SELL A PARTICULAR SECURITY.