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The Congressional Effect: A Pox on Both Houses

By Ari Charney on July 5, 2012

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The business world claims to hate uncertainty, particularly of the political and regulatory variety. That may account for what’s been termed the “Congressional Effect,” which is the apparent tendency of stocks to fall during periods when Congress is in session and rise when Congress is in recess. Of course, this behavior doesn’t always hold true in the short term, but it has been observed over the long term.

Indeed, one academic study examined the Dow Jones Industrial Average’s performance from 1897 through 2004, and found that more than 90 percent of the market’s capital gains occurred during periods when Congress was not in session. The performance data are compelling: The Dow returned 5.4 percent on an annualized basis when Congress was in recess, while it gained just 0.4 percent annually when Congress was in session.

Another study conducted over a 46-year period through the end of 2011 shows an even starker performance differential: The S&P 500 gained 16.6 percent annualized during periods when Congress was adjourned versus a 0.7 percent annual gain when Congress was in session.

Cynics might argue that even as corporations inveigh against heavy-handed legislation, they often simultaneously lobby politicians to ensure the rules are crafted in their favor. If such rules are promulgated for broad industries that account for sizable weightings in market indexes, then some legislative activity could conceivably be a boon to short-term market performance. Of course, even when such lobbying efforts are successful, they may simply exacerbate the unintended consequences of legislation, since the rules that favor one enterprise or industry may impose undue burdens on competitors.

Still, these data may not solely be a reflection of politics’ intersection with the business world, but could also tie in with the electorate. That’s because the former study noted an interesting wrinkle in the performance data. The strength of the Congressional Effect varies based upon the vagaries of public opinion. The stock market produced lower returns with higher volatility during those periods when Congress was in session and its approval rating was below 39 percent. However, that parameter may have to be adjusted, as Congressional approval ratings have been stuck below that threshold for quite some time and may remain so for the foreseeable future.

Congressional Effect Fund

Naturally, some investors have sought to take advantage of the Congressional Effect. To that end, Eric Singer, who conducted the second study cited above, launched the Congressional Effect Fund (CEFFX) in May 2008. The fund goes 100 percent long the S&P 500 when Congress adjourns and shifts 100 percent to cash and cash equivalents when Congress is in session.

Although the fund avoided the worst of the market’s losses during the Great Recession, it’s lagged the S&P 500 by double-digit margins over the one- and three-year trailing time periods. However, its largest rolling 12-month loss was just 9.8 percent, so investors who have been with the fund since inception are very nearly back to where they started.

One obvious hurdle to the fund’s performance is its 1.75 percent expense ratio, which is largely a function of the fund’s low asset base–at present, it has just $13.4 million in assets. And with the high portfolio turnover ratio (414 percent for its most recent year) necessitated by its strategy, the fund incurs a fair amount of brokerage commissions. Based on the fund’s year-end net assets, brokerage commissions added another 0.7 percent in expenses.

Additionally, when the fund goes long, it can invest its portfolio in exchange-traded funds or futures contracts that mirror the market’s performance. Its most recent portfolio snapshot, for example, shows its portfolio divided between the SPDR S&P 500 (NYSE: SPY) exchange-traded fund (ETF), which has its own expense ratio of 0.09 percent, and S&P 500 E-Mini futures contracts.

Because the fund spends much of the year idling its portfolio in US Treasury Bills when Congress is in recess, it looks like the fund’s management hopes its leveraged bets via futures contracts will magnify returns during the relatively brief period when it’s invested in the market. But leverage works both ways, and it may be impairing the fund’s performance more than boosting it.

Even with the imprimatur of academia, I don’t entirely buy the fund’s premise. There are an extraordinary number of variables that can impact the market’s performance, so it seems overly simplistic to hew to such an approach, regardless of one’s perspective toward our elected officials.

Norman Fosback’s Seasonality Timing System

In reading about the Congressional Effect, I noticed that researchers at first assumed that they might merely be observing a form of stock-market seasonality. They later dismissed that theory, but the fact that such an approach requires one’s portfolio to remain sidelined for most of the year reminds me of another mechanical approach to investing that utilizes seasonality: Norman Fosback’s Seasonality Timing System (STS). In fact, Mark Hulbert believes the STS may be the best market timing system of all time.

Fosback is one of the rare editors in the investment newsletter world who applies academic rigor to his investment process. He devised his STS after noticing the market exhibits unusual strength during certain periods, such as holidays and turns of the month. While this pattern might be explained by underlying investor behavior, the system seems to benefit just as much from avoiding being in the market for roughly two-thirds of the year. That also means the STS tends to lag the market during short-term bull runs, while outperforming over long-term periods that include bear markets.

The Hulbert Financial Digest has tracked the original STS since the beginning of 1982. Through the end of 2011, the STS beat the market by 0.3 percentage points annualized, while incurring 39 percent less volatility. Though the HFD normally includes the effect of commissions in its calculations, its performance data for market timing systems does not include commissions.

Though Fosback no longer formally publishes his original STS, investors interested in replicating the strategy can refer to a column Hulbert wrote in 2003 that explains the three rules governing this system. In fact, it’s possible to sit down with a calendar and plot the trades years in advance. The main downside to this strategy is that it requires 34 trades a year, which means it’s only suitable for a tax-advantaged account.

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