Risk & Opportunity

A quarterly political and economic newsletter published by Michael Cuddehe

Q1 '07

The Presidential Cycle and Mideast Tensions

One of the useful tools for divining the future course of the stock market is the basic four year cycle that tends to peak shortly after presidential elections and is thus called the Presidential Cycle. Like all cycles it can be useful for analyzing past market behavior, but tricky to use projecting forward. Cycles in markets can run like clockwork for long periods of time and then suddenly disappear, become intermittent, or even invert for periods of time. The point is that cycles are useful tools, but they are not guaranteed; they need to be used in combination with other analytical tools.

The rationale for the Presidential Cycle is that any major economic policies that may cause hardship are likely to be implemented early in the presidential term in hopes that the economy will recover in time for the next election. Conversely any opportunities to relieve hardship and stimulate the economy will be implemented as the major four year election approaches, thus improving the chances of re-election for the party in power.

The average presidential cycle from 1897 to present is shown in the following chart, courtesy of Dogs of the Dow.

Dogs of Dow

The chart demonstrates that most of the stock market gains over the last 100 years have been realized during the two years preceding presidential elections. If you look closely you can see that the cycle tends to bottom in September — October just prior to the mid-term and top out in March following the presidential election. Any readers who might choose to trade on this information should keep in mind that individual years can deviate widely from the average, and also that some of the largest corrections in stock market history have been in October.

The last election cycle peaked a year early in March of 2000 and bottomed on schedule two and a half years later in October of 2002 after a 44% decline (S&P 500). It then proceeded to climb from its mid-term lows into the 2004 election, for an overall loss on the cycle of 22% (year end). The current cycle has so far had a more bullish cast, up 17% in the bearish post-presidential period. On a strictly cyclical basis, that should bode well for gains through March of ’09.

Does this mean we should expect a raging bull market for the next two years? I think not. With all the headwinds facing the economy and the excesses of past and present weighing on the market it’s hard to get too excited about the upside. Furthermore, the primary drivers of the move up from the ’02 low — wage savings from globalization and outsourcing, gains in productivity from the technology boom of the ‘90’s, and massive fiscal and monetary stimulus — have all seen their best days.

However, given cyclical realities and massive global liquidity it’s not time yet for a serious and extended pullback. So with all the caveats about unexpected events, I expect the stock market to be sideways to higher over the next two years with the market tracing out a major top in preparation for the real correction which will begin in ’09. Volatility will increase, with a good chance of at least one nasty correction, but overall the Presidential Cycle will likely hold and the market will continue to “climb the wall of worry.”

Housing

Despite the headlines, the housing market is not falling apart. Housing certainly has its problems…see “The Trouble With the Housing Market” in the March 24th Economist. But houses are still being built and sold; just not at the white hot pace that we have seen in recent years. In fact housing is doing reasonably well by historical standards. 2007 starts are currently projected to be about 1.50 million, which is not far off the average (1.532 mil) for the years 1995 through 2001. It is only compared to the peak years of 2004 and 2005, which averaged over 2 mil, that ’07 looks weak.

Problems in the sub-prime sector have been hyped in the press, but sub-prime is just one sector of housing, about 10-12% of the total, and problem loans, which might be as much as 15% of that total, amount to less than 2% of the total housing market and about 1/10th of 1% of GNP. Furthermore, structured finance has allowed the mortgage risk to be spread far and wide making the probability of major bank failure or systemic damage somewhere between remote and nil at this point. So, while the problem loans are very stressful for the affected mortgage holders and for dedicated sub-prime lenders, many of whom have already declared bankruptcy, the impact on the system as a whole is not much…yet. If we get into a real recession then we will have a different story to tell.

This does not mean that housing is not overvalued or that there are not imbalances that need to be corrected, but it remains to be seen whether the needed correction will be achieved through an extended period of flat to slightly lower prices, or through a washout. Considering the amount of political capital riding on the housing market, it is certain that every effort will be made to uphold nominal house values.

Politics

This is a very exciting time politically as the authoritarian Bush Administration butts heads with a determined opposition in Congress. The main event currently is the Iraq war but many other points of conflict are breaking out as the new Democrat Congress begins scrutinizing the activities of the Administration after six years of a rubber stamp Republican Congress. The current hubbub over the firings of DOJ prosecutors is certain to be just the first of many dust-ups, and probably a constitutional crisis or two before it’s all over.

Over the next two years numerous issues regarding the balance of powers and the exercise of executive power are likely to be decided in the Supreme Court, including the limits of executive privilege (silly us…we thought that was settled with Watergate), whether the President can make a law passed by Congress more to his liking by simply attaching a “signing statement,” and possibly the limits of the powers of the Commander in Chief. Noteworthy regarding this last issue is that Samuel Alito, the newest Supreme, is a proponent of the “unitary executive” theory, which among other things states that the President has absolute power in wartime…all the incentive some Presidents might need to make sure we are always at war, and a bad idea if ever I heard one. Wild cards are potential terrorist attacks on U.S. soil and/or expanded war in the Middle East. In a crisis the Court is likely to defer to the Executive, a tendency certainly not lost on the Administration.

Things are going to get really interesting if a Democrat wins the White House in ’08. I think it would be fair, and even kind, to say that the Bush team has had a rather cavalier attitude toward the law. It will be “the mother of all scandals” as one commentator put it when the lid is lifted on the secret activities of this administration. What we are seeing now is just a teaser.

Republicans are in a funk. Their presidential candidates are a bunch of old white guys with not much to sell but the ageing vision of Ronald Reagan. Many in the rank and file are disillusioned with their leadership and some have even thrown in the towel on the party. See the Salon interview with Bob Barr, one of the Clinton inquisitors in the House, who has abandoned the party.

Democrats are trying hard to exercise party discipline and control their exuberance over the destruction Republicans have heaped on themselves. They are playing it safe, being firm but not overly aggressive in their opposition, and hoping to coast into the White House and total control of government on the tails of the Bush implosion. Unfortunately this caution has rendered Democrat presidential candidates even more prone to uttering platitudes than usual, most importantly regarding Iraq, where real policy substance has been missing from the outset and is most desperately needed. See Andrew Bacevich’s op-ed ”’Your Iraq plan?’ Is a Baseless Question” in the April 9th Los Angeles Times.

Geopolitical

A great deal is happening on the global stage: growing Russian anger at the U.S., the Taliban resurgence, the North Korean “deal” (promptly violated by North Korea), a short lived Venezuelan coup, the early stages of a nuclear arms race, and much more. But all of this is only faintly visible in public awareness as the world stands transfixed by the debacle unfolding in Iraq and the looming prospect of regional war in the Middle East.

The Iraq War, and the belligerent foreign policy that spawned that war, have caused a huge loss of stature on the global stage for the U.S. On the plus side, if you can look at it that way, the resulting mid-term drubbing seems to have woken President Bush from his delusions on foreign policy. Beginning with the removal of Donald Rumsfeld and installation of Robert Gates as Secretary of Defense, the Bush Administration has been steadily retreating from its “my way or the highway” foreign policy.

With North Korea, Iraq, Palestine, Iran, Russia and elsewhere, attempts at dialogue, negotiations and compromise have replaced intimidation, outright threats and contemptuous disregard as the preferred mode for engaging other countries. While it is a relief to see the Administration actually trying to deal with other nations rather than bully them into submission, six years of neo-con foreign policy has created so much anti-American anger, mistrust and chaos that the question now is: does this administration have any credibility at all on the world stage and can it actually do any good or will we have to wait two years for a new group to begin to repair the damage? See the “Sidelined by Reality” in the April 19th Economist on the downfall of the neo-cons.

On January 5th the New York Times published an insightful commentary by Slavoj Zizek on the myopic vision of American foreign policy makers and the consequences of their policies. His argument is that America has used its considerable power to undermine distasteful but predictable regimes in the Mideast, thus delivering power into the hands of our most implacable and unpredictable enemies, while at the same time earning global enmity by confusing our position as global hyper-power and policeman on the one hand and as a nation-state on the other. By using the power of empire to aggressively pursue one-sided “America first” policies we have demolished the foundation of empire, which is the support and cooperation of the subordinate nations because their interests are being considered and their needs met.

I would add that the realignment stimulated by these misguided policies is now irreversible. The short-lived age of America as global hyper-power is over. It is ironic that efforts to implement the neo-con fantasy of total global domination have resulted in the beginning of the end of their beloved American empire. But then again this is the inevitable consequence of hubris.

The military is paying a severe price for the policies of George Bush’s A-team. (Remember the A-team?) Read Time magazine’s April 5th cover story, “America’s Broken Down Army.” The “surge” is putting a huge strain on the Army, coming on the heels of extended and ongoing deployments in Iraq and Afghanistan. The generals tell us the increase in troops can only be sustained for about six months without doing serious damage to the military’s overall readiness, yet plans are already being laid to extend indefinitely. I have heard nothing about how these two realities are going to be bridged. It appears that the plan is to try to ignore the problem until it can be handed off to the next administration.

The President and Congress have locked horns over Iraq war funding, with Congress demanding a withdrawal timeline, and the President adamantly refusing. However, this battle of wills could become moot if tensions with Iran should erupt into open conflict. The drumbeat in the mainstream press has been that there is a consensus that there is no military solution to the Iran problem. Don’t believe it. There is a vigorous ongoing debate on this issue and the positions range the spectrum from “military intervention won’t work” to “military action is the only solution.”

Things have certainly improved from only a year ago when the neo-cons were still in charge and plans were being made for an attack on Iran including the use of tactical nukes. See “The Iran Plans” by Seymour Hersh in the April ’06 New Yorker. Since the changing of the guard, sentiment on Pennsylvania Avenue has shifted to favor at least a serious effort at a diplomatic solution, which means economic sanctions, negotiations and containment if sanctions and negotiations fail. However, the diplomatic track has only so long to yield concrete results.

A nuclear Iran is a grim prospect for the U.S., and for the world, but it is utterly unacceptable to Israel. Iranian leaders have repeatedly stated their intention to “wipe Israel off the map.” Unofficially the talk is that if Iran doesn’t yield to diplomatic pressure within a reasonable time frame, and so far there is no reason to think that they will, then Israel will have no choice but to go after them if we don’t. If Israel does take the lead we will back them totally.

For its part, Iran has threatened to cut off the tanker traffic flowing through the Straight of Hormuz, conduit for 20% of the world’s oil supply, if it is attacked. In that event, $100 a barrel oil is probably a conservative estimate. Osama bin Laden must be pleased. If you remember, his initial objectives were $50 a barrel oil and U.S. troops out of Saudi Arabia.

To top it all off Dick Cheney is now talking about a “20 or 30 or 40 year” conflict. This guy definitely lives in his own world. See the CNN interview with Cheney.

For those interested in gaining broader input on the prospects for war with Iran the following links feature a range of information and opinions:

Meanwhile, the Islamic jihad against America is metastasizing. Arab “moderates” who after 9/11 were willing to acknowledge that extremism and terrorism in the Arab world were problems that they needed to deal with, are now blaming all problems in the Middle East on Israel and America’s policies in support of Israel. See David Brooks’ op-ed, “A War of Narratives.” Also, Islamists and Communists, two groups which until now have had nothing but loathing for each other, have found common cause in their hatred of America. See “Anti-Americans on the March” in the December 9-10 Wall Street Journal. And if you want to get a good sense of how the toxic culture of martyrdom is spreading, see the May 4th NY Times article, “Jordan’s Jihadists Long to Kill and Die in Iraq.”

Summary

At this point geopolitical trends and market cycles are in conflict. There is a very real prospect of chaos overtaking the Middle East as early as this summer. War is not always a negative for the markets, but a general war in the oil producing Mideast would certainly deliver a global economic shock. Meanwhile, markets are discounting the current economic slowdown as temporary and cycles point upward going forward. What could bring the two trends into harmony would be an unexpected positive development on the geopolitical scene.

For the most part Republicans are still supporting the President’s open ended war policy but they are losing the political battle at this point, and absent some unexpected event will continue to lose ground until they change their tune. As we approach the election the pressure will be intense for Republicans to abandon the President and start looking for resolutions, or at least the appearance of resolutions, to the conflicts in the Middle East. High stakes; high drama. Someone should write a script…???...maybe someone already did!

The bottom line in the marketplace is that complacency rules but risk continues to escalate. I do not believe the bottom will fall out of the markets over the next two years, but I do expect increasing volatility, at least one substantial correction of 10%+, and a major top developing. Some commentators are calling for recession in ’07 but most economists are expecting the current period of slower growth to lead to a renewal of economic expansion this summer, BCA Research notable among them. The entire recovery from the ’02 low has been anemic by historical standards and I believe that the renewal of the expansion will be even more anemic, setting the stage for a major markdown in ’09-10. The housing market, which has finally topped out, will not collapse, but it will not go back to a bull market either. The dollar will be volatile, and will remain under pressure.

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