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WHAT ABOUT THE POSSIBILITY OF A BEAR MARKET THIS YEAR? May 1, 2007.
For now we are expecting only a normal 15% correction in the blue chips (20% in the Nasdaq) in the market's unfavorable season, once we get the exit signal for our Seasonal Timing Strategy.
We've been asked about the odds of a bear market this year. Is it possible we'll experience one?
Yes, it is possible, especially if the odds increase much more that the economy will slow all the way into a recession. There has never been an economic recession that was not accompanied by a bear market.
Some other reasons that make it possible:
No one expects one.
And the market is notorious for doing whatever it takes to make the majority (the crowd) wrong. And right now hardly anyone is expecting a bear market. Those who are bullish don’t believe there will even be a 10% correction. Those who are bearish, including ourselves, expect only a correction of 15% or so and then a resumption of the bull market.
One of the factors keeping analysts from expecting a bear market is that the last two years of the Four-Year Presidential Cycle are almost always positive. There is a strong history of the economy and stock market experiencing difficulties in the first two years of each Presidential term, and then experiencing strong growth in the 3rd and 4th year of each Presidential term.
The driving force behind the cycle is the economic ‘pump-priming’ out of Washington beginning in the 2nd and 3rd year of each presidential term. Political parties learned many decades ago that the most important factor for voters at election time is the condition of the economy. Regardless of how positive other factors may be at the time, almost no incumbent party has ever been re-elected if the economy is struggling when voters go to the polls.
Therefore, it has been common since at least 1918 for the incumbent Administration to do whatever it takes in the last two years of each Presidential term to make sure a prosperous economy and stock market are in place in time for the next election. Such pump-priming traditionally includes increased government spending, cuts in interest rates, tax cuts, even tax rebates. The intent is to encourage businesses to increase their capital spending and hire more workers, and to encourage consumers to spend.
It does not always work to get the incumbent party re-elected, but it almost always works to create a strong economy and stock market by the time the next election rolls around.
The problem is that the stimulus efforts in the last two years of each Presidential term almost always result in the economy and stock market being pumped up too much. Excesses are created that need to be cooled off and corrected after the election. Those excesses include some combination of an overheated economy that is threatening to produce inflation, an overbought and over-priced stock market, perhaps a ‘bubble’ in one or more investment area, and excess government, consumer, or corporate debt.
So after the election, the Administration wants the correction of those excesses to take place in the first two years of the new term. If market forces are not producing the corrections, Washington often forces the issue by raising interest rates to cool off the economy, while backing off on government spending and job creation.
It makes sense that they want the economy and stock market to undergo any needed correction of excesses in the first two years of the new term. If they tried to keep the economy and stock market pumped up for another four years, all the way to the following election, they would run the risk of even greater excesses developing. That in turn might result in an even larger economic and stock market correction late in the term, when they might not have enough time to get the situation turned around in time for the next election.
The result has been that since at least 1918 there have almost always been problems in the first two years of each term, but then a substantial rally from the low in the 2nd year of each term to the high in the 3rd year, rallies in which the Dow and S&P 500 gained an average of 50%.
However, the pattern of a serious correction in the first two years of a presidential term did not take place in President Bush’s 2nd term. The Dow gained 1.6% in 2005, and 18.5% in 2006. That raises the question of whether the last two years of the term will be able to follow the historical pattern - of being positive.
Two previous times that the pattern (of weakness in the first two years and strength in the last two years) did not take place were also when a president had been elected for a second term.
The market did not have a serious correction in the first two years of either President Reagan’s or President Clinton’s second terms. And both times the normal pattern of strength in the last two years of those terms did not take place either. For Reagan, the 1987 crash took place in the 3rd year of his second term. And the 2000-2002 bear market began in the 4th year of Clinton’s second term.
For example, in the following chart we have marked the low in the 2nd year of each term with an A. Note that the market had no correction in the first two years of Reagan's second term. So there was no real low in the 2nd year. Even so, from that low marked A the Dow still began an impressive rally that continued into the third year. But part way through that third year the market ran into the 1987 crash in which the Dow lost 36% of its value.
And as noted, the market also did not have a correction or a serious low in the first or second year of Clinton's second term. And sure enough the excesses were not corrected, and the market's severe 2000-2002 bear market began at the beginning of the 4th year of the term.
The BUSH second term has a similar look.
As shown in the following chart, President Bush's 1st term followed the historical pattern of problems in the first two years, and then a significant rally from the low in the 2nd year. In fact, the severe 2000-2002 bear market ended with that low.
However, President Bush's 2nd term has not followed the pattern. Just like Reagan's 2nd term and Clinton's, there was no serious market correction in 2005 or 2006, the first two years of the 2nd term. In fact, as has been noticed by most everyone, this bull market has not had even a 10% correction since 2003.
Yet, as called for by the Presidential Cycle, and just as also happened in Reagan's and Clinton's 2nd terms, from what low there was in the 2nd year of Bush's 2nd term, the low last July marked A, an impressive rally was launched that has continued on into this year, the 3rd year of the Bush 2nd term.
So the question is whether the 3rd and 4th year will be positive, as is called for by the Presidential Cycle, or will they have problems like in the Reagan and Clinton 2nd terms, because it is a president's 2nd term and there was no correction of the excesses in the 1st two years of the term?
It does seem that the consistent pattern of the market suffering serious losses in the first or second year of a president’s term, and then being positive in the final two years, is not consistent when it is a president’s 2nd term.
And this time, as with the Reagan and Clinton 2nd terms, we are in the 3rd year of the Bush 2nd term without the excesses from the final two years of the first term having been corrected. So we have the typical excesses of inflationary presuures, an overbought and over-priced stock market, a ‘bubble’ bursting in an investment area, excessive government & consumer debt, etc. usually seen at market tops.
So, yes, although bear markets are rare in the 3rd year of presidential terms, it is possible. We do have the precedents of the Reagan and Clinton 2nd terms.
Additionally, we are in the 7th year of the decade.
The pattern for 120 years has been for the 7th and 10th years of the decade to be the most negative. In fact, they have averaged losses.
It’s also interesting that not only did the 1987 crash, and the beginning of the 2000-2002 bear market take place in the last two years of the Reagan and Clinton second terms, but the first event was in the 7th year of the decade, and the other in the 10th year. And here we are in the 7th year of this decade, with similar situations and conditions.
We don’t want to mislead you. While the 7th year has averaged losses over the last 12 decades, it was down in only six of those decades and up in six. (Its long-term record is so negative because when it was down in a 7th year, it was usually down significantly).
So, the Four-Year Presidential Cycle cannot be depended on to save us from a bear market this year. And the Decennial Cycle supports the thought. As do signs that the economy is slowing possibly into recession, etc.
So we do not rule out a bear market, and will be watching closely once our Seasonal Timing Strategy (STS) receives its exit signal into its unfavorable season. Until then, the STS portfolio remains 100% invested in the S&P 500 Index (since the entry last October)
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