Montreal, Canada

Based on the historical stock market cycle how will U.S. equities perform in 2010?

Developed by Yale Hirsch decades ago, the theory states that U.S. stock markets are weakest in the year following the election of a new U.S. president. Accordingly, after the first year, the market improves until the cycle begins again with the next presidential election.

The first year of a president's four-year terms is usually the worst for stocks since the incumbent introduces legislation and economic policies that might not be market friendly.

The history of the Presidential Cycle is that the economy and stock market tend to have problems in the first two years of each new president's term and then recover providing solid returns the last two years of his term. But in 2009, Obama's first term, stocks rallied 20% -- defying the historical trend of poor performance in Year I of the presidential cycle.

Unfortunately, history doesn't lend much evidence that stocks will rally or decline in Year II of the cycle. The data asserts, however, that stocks will muster a small gain in 2010.

According to research courtesy of RBC Capital Markets, the Dow Jones Industrials Average has gained an average 5.46% return in the second year of the presidential cycle; of the 16 presidential cycles since WW II, nine have been positive and seven have been negative.

In 2006, after George W. Bush was re-elected, the Dow gained 16.3%. But in 2002, the Dow plunged 16.8%, which marked its third consecutive annual decline following the dot.com bust.

The best second year of the presidential cycle was in 1954 when the Dow gained 44% followed by 34% in 1958 and 22.6% in 1986.

The market also tends to perform better under Democratic presidents than Republicans.

The worst years for this series occurred in 1974 when the Dow tanked 27.6% followed by 19% in 1966 and 16.8% in 2002.

In my book, the above data is pretty useless as a forecasting tool in 2010.

However, using historical data from the 1930s – an environment similar to today but far worse in terms of resultant economic damage – the stock market bottomed in the summer of 1932 before rallying more than 400% until 1937. Then hell broke loose again.

FDR was first elected in 1933 (a great year for the Dow) and in 1934 the Dow logged another fat gain in Year II of the presidential cycle – almost the same return produced under Obama amid a credit bust the previous year; but from March 1937 to March 1938, after FDR was re-elected and in Year II of the cycle, the Dow almost halved, plunging 47%.

Importantly, starting in 1937 the Fed began to withdraw monetary stimulus following a massive dose of money creation during the Great Depression. The economy thereafter went into a tailspin by mid-1937 as the Fed continued to hike interest rates.

What we can surmise from the last credit implosion in the 1930s is that if the Fed begins to prematurely withdraw monetary stimulus and begins raising rates, then stocks might decline sharply just as they did in 1937. The market underestimates the power of government lending, which is pervasive across the economy (especially mortgage origination), acting as the most important source of credit intermediation since 2008.

Or, the markets might take long-term rates much higher amid a deluge of global bond issuance again this year. Sharply higher long-term rates would suffocate mortgage financing and induce another bear market or, possibly, trigger a crash.

If the Fed starts hiking this year, just as it did back in 1937, a double-dip recession grows increasingly probable by 2011.

The Fed badly miscalculated the strength of the economy in 1937 and Fed boss Bernanke knows this all too well. That's why my best guess is that he'll overshoot in this cycle and create mountains of credit before it's all over.