Kathy Valentine
+1 (434) 951-5348
kathy.valentine@cfainstitute.org
Jessica Galehouse
+1 (434) 951-5376
jessica.galehouse@cfainstitute.org
The Presidential Term: Is the Third Year the Charm?
New study shows that stocks generally prosper during the third year of a presidential cycle, while Fed policy tends to be unusually accommodative.
Charlottesville, Va., April 18, 2007 – In a recently completed academic study, the authors of two widely-recognized articles on the political environment and security returns analyze the “third-year effect.” One quarter in to the third year of the current presidential term, this timely study seeks to add explanation to the mysterious “third-year effect.”
In their study, “The Presidential Term: Is the Third Year the Charm?”, co-authors Robert Johnson, Ph.D, CFA., managing director of the CFA Institute Education department; Scott B. Beyer, Ph.D, CFA, assistant professor of finance at the University of Wisconsin Oshkosh College of Business; and Gerald R. Jensen, Ph.D., CFA, professor of finance at Northern Illinois University College of Business, show that equity returns are significantly higher during the third year of a presidential cycle. Furthermore, the authors note that this result may be facilitated by the Federal Reserve’s willingness to maintain an accommodative monetary policy during the latter stages of the sitting President’s term.
The study, which is forthcoming in The Journal of Portfolio Management, considers stock returns during each of the four years of the presidential term. The authors find a prominent pattern, whereby stocks generally languish during the first two years of a presidential term and prosper during the final two years. The third year is shown to exhibit by far the best stock performance. An examination of fiscal and monetary policy measures identifies a corresponding pattern in Fed monetary policy. Specifically, Fed policy is significantly more accommodative in the second half of a presidential term relative to the first half. Interestingly, like the return pattern, monetary policy measures suggest year three is the most accommodative year of the term. Overall, these findings are consistent with the conventional view that policy makers are reluctant to assume a restrictive stance in the months leading up to a presidential election. Consistent with this view, restrictive policy actions are more commonly initiated in the early years of a presidential term, while expansive policy actions are more likely to occur later in the term.
The key empirical findings reported in the study include the following:
- Between 1957 and 2004, returns for large-cap equities averaged 6.9 percent, 4.9 percent, 23.8 percent and 13.3 percent, respectively, for the four-year presidential term. Thus, during the 48-year study period, year-three returns have been nearly triple the average return earned during the first, second and fourth years.
- The dominance of third-year returns is more pronounced for small-firm equities. Small-cap stocks earned 12.1 percent, 3.4 percent, 38.0 percent and 20.8 percent, respectively, during the four-year presidential term.
- Broad monetary policy measures indicate that, during year three, Fed policy has been expansive 65 percent of the time, while Fed policy has been expansive only 48 percent of the time during the other three years.
- The fed funds premium (federal funds rate minus the T-bill rate) indicates that monetary policy was most stringent during the first year of the presidential term and most relaxed during the third year. Over the four-year presidential term, the premium averaged 0.68 percent, 0.66 percent, 0.32 percent and 0.44 percent, respectively.
“While the study does not guarantee that investors will see superior equity returns by the end of the calendar year, it does provide some rationale for the persistence of this calendar effect,” said Johnson. “Furthermore, the evidence is consistent with the view that Federal Reserve’s easing of interest rates later this year may be a necessary ingredient for the continuation of the ‘third-year effect.’ Overall, our evidence confirms the view that effective portfolio strategies require investors to carefully monitor both monetary and fiscal policy developments.”
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