Current valuation makes market difficult to predict for second term

By DAVID MOON, Moon Capital Management, LLC
November 11, 2012

One of the more frequently offered finance observations this time of year is that the stock market has historically performed better with Democratic presidents in office rather than Republicans.

Since 1900, the US stock market returned an average of 15.35 percent annually when a Democrat resided in the White House, compared to only 8.61 percent for Republicans.

After Tuesday our investment woes are over, at least for the next four years.

But are they?

There’s actually a negative correlation in stock returns between a president’s first and second terms in office.

The stock market increased 32.8 percent annually during Franklin Roosevelt’s first term then the market declined over his subsequent two full terms, averaging an 11 percent annual loss in the second term and an almost two percent annual decline in the third term.

In Ronald Reagan’s first term in office the stock market increased a scant 0.70 percent annually. In the second four years, however, the S&P 500 return was a more robust 12 percent annually.

Since the S&P 500 increased 16 percent annually during Barack Obama’s first four years should we expect the market to reverse course and perform poorly in the next term – despite the historic market performance under Democrats?

If you really want to know how the stock market is likely to perform during a president’s four-year term, look at the valuation of the market at the beginning of the four-year term. Since 1900, there has been a strong negative correlation between P/E ratios and subsequent four-year returns coinciding with presidential terms.

The P/E ratio at the beginning of FDR's first term in office (the 32.8 percent annual return term) was 7.9. Low P/E, high stock return. When the stock market increased 21 percent during Eisenhower’s first term, it started from a P/E of 11. President Obama came into office with a P/E of eight, setting the stage for the outstanding stock performance over the past four years.

Stocks didn’t have a chance during the first term of George Bush (43.) The P/E ratio on January 2001 was 26 times earnings. The annualized rate of return over the subsequent four years was negative 7.8 percent.

The market currently sells at about its long-term average: 15 times earnings. The historical average rate of return from this multiple is about 10 percent annually, although the range varies significantly.

Bill Clinton’s second term began with a P/E ratio of exactly 15. The S&P 500 increased an average of 19.2 percent over the next four years

When Harry Truman was elected in 1948 the P/E for the overall market was 14.2; stocks returned 11.4 percent annually over the next four years. At the beginning of FDR’s third term, the S&P 500 sold at 13.9 times earnings. It subsequently lost 1.8 percent annually over the next four years.

When valuations are at their extremes, it’s easy. When the overall market sells at six times earnings, you can almost throw darts at the newspaper and make money. When P/Es exceed 25, it is difficult not to lose money.

Today we sell in the middle and things are harder in the middle – regardless of who is president.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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