I have been privileged to own a small airplane for many years. It's a nice little Cessna 182. We've had many wonderful family trips aboard that airplane.
I am instrument-qualified, meaning we could fly in most any kind of weather, but the fact is that it's a Cessna 182, not a B-52 Flying Fortress. When the weather is bad, we just don't fly. It's not that we can't fly; it's uncomfortable being bumped around in a small airplane during turbulent weather.
I have a similar feeling about my stock portfolio. When I see the investment weather turning sour, my general attitude is to sit it out. It's not that we can't successfully fly through sour investing weather. It's just uncomfortable. So I like to scan the horizon and look for potential storms. It seems a reasonable behavior for someone who pilots a small portfolio, like most subscribers to Inside Value.
Recently, I've been looking back through old investment books. A lot of smart people think our current investing environment is similar to the one during the 1960s and 1970s, so I went back and looked at the investing advice books published in the late '70s and early '80s. I figure that about the time pundits clinch an appropriate investing strategy, the markets change away from them.
In my research, I came across an interesting discussion of election cycle in investing. The historical record suggests that there are certain periods that are better for buying stocks, selling stocks, and for staying out of the market in general. Many years ago I read an interesting book, Edward R. Tufte's Political Control of the Economy, which was written in 1978. Tufte presents hard data on how the economy has been orchestrated; his figures show that increases in federal spending, Social Security, and real disposable income have either been larger or more frequent (sometimes both) in presidential election years. After a president takes office, the economy usually has to pay the price for policies designed before the election.
Further, a price is paid for the neglect of problems that require unpalatable remedies, creating a correlation between the presidential election cycle and the business cycle. The average duration of the business cycle has spanned about 48 months. It's interesting and obvious to note that this correlates very well with presidential election cycle.
In the late '70s, investors developed a strategy to take advantage of election-cycle investing. You would buy a diversified portfolio of stocks on Nov. 30 of the second year after a presidential election, then hold for two years. You sell your entire portfolio on Nov. 30 in the presidential election year and put money in Treasury bills or money market funds. From 1960 until 1982, this strategy worked remarkably well. But from 1982 to 2000, the greatest mistake you could make was being out of the market. Thus, election-cycle investing was forgotten.
Let's take a stroll through the last 50 or 60 years. We'll start in 1940, near the end of the 1929-1942 secular bear market. The election-year return in 1940 was minus 15%. This was the third election for Roosevelt, our only king. In 1944, our return was about 14% while 1948 was flat. I liked Ike in 1952, and we showed a return of 12%. Next up, 1956 was flat, as was 1960.
The following year showed a major market rally. That carried us into the 1964 elections and the end of the last bull market. This is where it gets interesting.
The 1964 election return was 12.5%, and it was the first election I clearly remember. Barry Goldwater, Lyndon Johnson, the Cuban missile crisis, and a commercial with a little girl watching the world explode in a nuclear flash. If there were ever a president who would attempt to manipulate the economy for his gain, it would've been Lyndon Johnson.
In 1968, the market returned about 7.5% while we sat on a dock of the bay and Vietnam rolled on. The following two years, the market dropped like a rock. Remarkably, in 1972, the market returned a positive 15.5% while we climbed a stairway to heaven and re-elected President Nixon to the tune of Watergate. The ensuing two years showed a major market decline.
Surprisingly, the market had a wonderful year in 1976, returning almost 20% in the middle of Democrats, Jimmy Carter, Sex Pistols, dream weavers, and afternoon delight. The following two years showed a terrific decline.
The election year of 1980 showed 25% gain in the market while AC-DC shook my children all night long. The market took back all of that gain during the next two years and declined into 1982.
In 1984, the market was flat but had a terrific two years following the election. These were the days of Reaganomics and Karma Chameleons. The market continued to climb in the years that followed, and we were off to the races with the Grand Bull Market.
So, is there a message in all these numbers? I think it shows that presidents and the legislature cannot really change the grand economic cycle. However, during turbulent times, they can temporarily plug holes in the dike. It takes careful orchestration to make the economy sing the appropriate melody to the beat of quadrennial elections. Our elected officials, be they Republican or Democrat, serve their self-interest. In election years, economic policy tends to overstimulate growth and the market. Through the secular bear market of the '60s and '70s the market hummed perfectly in election years and then lost its tone every year that followed.
Let's think back to piloting our little portfolio through turbulent weather. There has been tremendous stimulus applied to the economy over the last two years. Nevertheless, the economy chokes and sputters and haltingly moves forward. There will be no tax rebates next year. Depreciation schedules are returning to their usual pace. Interest rates are rising away from multigenerational lows. Other stimuli are going to wind down. I think there is an excellent chance that we will see the same general pattern noted in the years from 1962 through 1980, when the economy is stimulated the year prior to a presidential election, then we pay the price for the ensuing year or two, regardless of which party won. If that pattern holds, there is a real likelihood we will see a substantial market decline over the next 18 to 24 months.
Is there a way for Inside Value types to profit from this observation? I think so. I would make every effort to be circumspect and very careful with my investing decisions over the next two years. I will ratchet up the requirements for my margin of safety. I will hold back some portion of cash for the big "stock market winter sale," which is likely to occur.
I am not going to sell all my stocks and hide under a rock for the next two years. If I see a great bargain, I'm certainly not going to pass it up. I want to own great companies with growth prospects where the dividend is stable and supports the equity price. Merck
I want to remember that cash is a position, too! I'm going to remember that time and patience are the individual investor's best friend. So I'm going to put on my investing uniform -- the thin tie from 1960, my bell-bottoms from 1969, my leisure suit jacket from 1977 -- and I'll wait for great investing chances to come to me. I won't have to look furiously for them. I'll watch month to month. I won't feel the need to have all my money invested at all times, any more than a poker player feels the need to play every hand.
Meanwhile, I'll kiss my wife daily, pet the dog, keep reading Inside Value when it shows up in my mailbox, and consider relearning a few disco moves. I don't want to overreact to the potential for poor weather and turbulence. I do want to be prepared. It seems the prudent thing for the pilot of a small portfolio to do.
Ed Miller owns shares of Bristol Myers, Merck, and Atlas Pipeline Partners. You can email him at firstname.lastname@example.org. The Motley Fool is investors writing for investors .