Deciding whether markets are over or under-valued involves a lot of arcana: forward vs trailing PE, CAPE, Tobin’s Q, investor sentiment, and a host of proprietary models might all give you different answers. In BMO’s quarterly letter, Jeremy Grantham explains two other investment rules that he hasn’t used since the late 70s, and why they should keep the markets going until the next presidential election.

Since 1964 there has been a striking pattern in S&P 500 returns versus the presidential election cycle. The first and fourth year of each term are mixed, the second year tends to be down, and the third year is strongly positive. The speculation, in line with the Greenspan-Bernanke-Yellen Put, is that administrations won’t allow the economy to explode a few months before America chooses its next president, and traders take outsized risks in response to this unspoken political backstop.

Grantham

The January Rule and ‘down downs’

For reason that are much less clear the January Rule, which says that move in January predicts what will happen for the year as a whole, has also proven to be reliable. Even more surprising, Grantham says that the first five trading days of the year has also been a fairly good reliable for the year’s fortune, and that when both measures disagree they are almost never wrong.

Since 1932, there have been 22 ‘up up’ years, with an average return of 11.6% from February to December and only one year, 1987, which ended down. In the same time frame there have been 14 ‘down down’ years, which have averaged -6.6% returns for the rest of the year, and again only have one positive outlier, 1982.

“Investors are very reluctant to take these two factors seriously. In fact, the factors are not respectable at all! They felt hokey and insubstantial 35 years ago and another very good 35 years of performance has not changed that,” writes Grantham. “Even as I studied these rules for decades I hardly used them at all, even personally… Today, older and wealthier and not exposed to career risk with my own money, I tilt a minimal amount away from ‘down down’ years and toward year 3.”

Estimating the end of the bull market: Grantham

This year is both the second year in the presidential cycle, which has traditionally been the worst, and a ‘down down’ year. Moving away from what feels like numerology, Grantham also points out that valuations are high, but not yet at the 2 standard deviation rise from trend that he says are one of the hallmarks of an asset bubble.

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Grantham expects that the stock market will continue to be difficult until the end of this year, but will pick up again in the winter and then rally for about 18 months until the next presidential election before crashing.

“Prudent long-term value investors will of course treat all of the above as attempted entertainment (although I believe all statistically accurate) and be prepared once again to prove their discipline and man-hoods (people-hoods) by taking it on the chin,” writes Grantham.