In the past 100 years, a clear pattern has been in place. The stock market has tended to trade in a similar fashion in each of the four years of a presidential cycle — that is to say, first-year results are similar from term to term, and so on. The logic behind such rational price action is quite simple: Presidential economic policies tend to follow predictable patterns that boost the chances a President (or his party) will stand a better chance of re-election.

For example, the first-year of a new term is characterized by policies that represent a break from a predecessor’s policies, usually based on populist-oriented policies that were made during the campaign season. This “feel good” environment has, on average, generated an 8.8% gain in the first year of a new presidential cycle, according to veteran Wall Street strategist Mark Hulbert.

#-ad_banner-#But once in office, presidents realize they will eventually need to rein in any policies that may lead to economic problems down the road. So by their second year in office, they are often looking to raise taxes, close loopholes, veto pork-barrel spending and enact other tough love measures. Think of Ronald Reagan’s second term, when he agreed to a series of tax hikes in 1986. He would never have done so if his party had been faced with an imminent presidential election. That’s why markets have historically been flat in the second year of a presidential term.

By year three, the President realizes voters will soon be thinking of the next election. In the ensuing months, the opposition party will step up its critical rhetoric and the field of potential candidates will start to come into focus. In response, the President will offer up a set of stimulative measures that will hopefully have the economy on a solid growth path a year later when the primaries and the election actually takes place. That helps explain why the stock market rises a whopping 15.5%, on average, in year three of the election cycle.

By the final year of a presidential term, the market tends to rise a respectable, though slightly subpar, 4.1%. The implications of why that is the case is unclear to me. It’s important to note that these cycles are calculated from September 30 to September 30, as that is the date generally regarded as the point when who the next president will be has been largely decided. It also coincides with the government’s fiscal year, when various policies take effect.

 

I was thinking about all of this when looking at the stock market’s recent performance. It may help explain why the stock market has been fairly robust in recent quarters, even after a strong rally that began in the spring of 2009. I and others had been expecting the market to pull back as investors booked profits. It never happened.

Yet here’s a curious data point: since the third year of the current cycle began Oct. 1, the S&P 500 has risen 14.9%. If this theory holds true, then we’re looking at less than a 1% gain from here until the end of September. That notion is further underscored by the “Sell in May and Go Away” theory that I recently covered.

Here’s the good news: The sharp sell-off that took place in late 2008 and early 2009 has put us behind the eight ball when it comes to historical trends. According to the presidential cycle theory, the market should rise around 25% in the first three years of the cycle. Yet since Oct. 1, 2008, the S&P 500 has risen only 17%. (The market actually lost half of its value from July 2007 to March 2009 and has since more than doubled from that March 2009 low).

If you look at the full four-year cycle, then we should expect gains of 30-33% (thanks to the power of compounding, the gain is greater than the sum of the four years). This means it’s reasonable to expect gains of roughly 15% between now and Sept. 30, 2012.

Action to Take –> To borrow a phrase from technical analysts, “the market looks over-extended.” The 104% gain in the S&P 500 since March 2009 is fairly unprecedented and appears to anticipate a great deal of good news yet to come. A pullback as we head into the summer should come as a surprise to no one. But if that happens, then it may well set the stage for further gains as we wind our way through the final quarters of the presidential cycle.

P.S. — Few investors realize that a 20-year energy agreement between the United States and Russia is about to expire. This deal supplies 10% of America’s electricity. As broke as our government is, the situation is so serious that President Obama is asking for $36 billion to avert this crisis. And Republicans support him. Here’s what’s going on…