By Matei Apolzan, Tudor Vianu High School of Computer Science in Bucharest, Romania, Alumnus of The Young Investment Banker Programme 2016
It is a fundamental tenet of behavioural finance that investors can observe and act upon patterns discovered in stock movements that are not backed by fundamental factors. Presidential elections in the US are not an exception to this phenomenon, as extensive literature has appeared concerning the interdependence between market performance and the various phases of the election cycle. However, which of the correlations observed truly reflect a cause-effect relationship embedded in the financial market?
Russ Koesterich, head of asset allocation for BlackRock’s global allocation team, writes: “Historically, whether a Republican or Democrat occupies the White House has had no statistically significant impact on US equity markets”. However, that is not to say that average returns of the stock market are similar for Democrats and Republicans. Bloomberg indicates that from the 1900 onwards, Democrat presidents witnessed annual returns of 9%, while Republicans observed a quite lower 6%. “Resolving the Presidential Puzzle”, an article in the Summer 2011 CFA digest investigates whether there is a risk-reward explanation at hand. Indeed, once the statistics are corrected for volatility the difference is merely wiped out; thus, higher risk, higher reward market activity is coupled with Democratic governments.
Nonetheless, many hypothesis correlating elections and stock markets concern the phases of the election cycle rather than the incumbent party. The Goldman Sachs Global Research team identifies the second year of an election cycle as the one most volatile, while Citi Investment Research & Analysis determine the first year as the worst-performing and the third year as the best performing, a particularly notable exception being 2008. Not only that, but the average returns in these years are significantly greater: 4.17% and 4.31% for the first two years of the election cycle, 11.26% and 7.77% for the latter two. An article based on four decades of market research, titled “Financial Astrology: Mapping the Presidential Election Cycle in U.S. Stock Markets” even posits that the stock market follows a precise pattern through the cycle. “Stock prices generally fell during the first half of a Presidency, reaching a trough in the second year, and rose during the second half of a presidency, reaching a peak in the third or fourth year.” (Social Science Research Network).
The election-stock market conundrum however does exhibit one striking correlation, though the cause-effect relation is the other way round. In the search for indicators predicting the U.S. elections winner, stock market performance stands out. Since 1900, whether or not the Dow Jones Index rose three months prior to the elections correctly decided if the incumbent party would re-win the presidential race 26 out of 29 times. Recently, even the U.S. President’s approval rating was highly correlated with the stock market, and research suggests the latter most probably influences the former.
Fascinating as it may seem, the link between equities and elections can only aid an investor so much. Essentially, the overall macroeconomy will always drive the stock market, and while the matter of the next president can help shape economic outlook and investor psychology, its influence remains shrouded in a thick cloud of uncertainty.