US Elections vs. the Stock Market - YouTube

- With the upcoming United States presidential election,

lots of investors are worried

about how the election outcome

might affect their investments.

This is not a new word.

Elections are stressful times,

and it seems obvious that the outcome

should impact the stock market.

Rhetoric from across the political spectrum

certainly doesn't help.

Fortunately, the relationship

between stock markets,

elections and political parties has been studied extensively

allowing us to step back from the rhetoric

to consider the historical data

and the theories that explain it.

In this episode of Common Sense Investing,

I'm going to tell you what the data say

about the relationship between US presidential elections,

including the contentious ones and stock market returns.

(upbeat music)

I'm not here to get political.

This video is simply about the data on the relationship

between the US stock market and US elections.

Let's start with the immediate short-term effects

of election results on stock market returns.

I've compared the returns

for the 12 months starting in November of election years

and non-election years from 1926 through 2019.

On average, the 12 months following an election

have delivered slightly lower returns at 10.6%,

than all other 12 month periods

starting in November at 11.9%.

Of the 23, 12 month periods following an election,

seven of them had negative returns,

19, 36, 40, 56, 68, 72, 76 and 2000.

While the rest were all positive.

Something that's important to consider in thinking about

whether an election result is going to be good or bad

for the stock market in the short run.

Is that all of us have our own political biases,

which affect our view of the world.

A person who aligns with a set of political views

will tend to think about their parties when

as good for the economy and the stock market.

These opposing views should be reflected in stock prices.

Meaning that a win for either party

will not be universally viewed as a good or a bad thing.

Muting its effect on asset prices.

This was studied in detail

in a 2012 paper titled "Political Climate Optimism

And Investment Decisions".

The author studied a large sample of data

from Gallup surveys,

the national longitudinal survey of youth,

and portfolio holdings and trading data

from a large US discount brokerage.

They found that individuals become more optimistic

and perceive the markets to be less risky

when their political party is in power.

This is important to keep in mind

before worrying that asset prices are going to collapse

following election result.

The market aggregates the expectations of all participants

not just those aligned with a given political view.

Prices are set at the equilibrium of all expectations.

Based on this, we wouldn't expect

any major stock market events to STEM directly

from election results.

Which is exactly what the data show.

Stock market volatility on the other hand,

may increase around elections especially tight elections.

In a 2019 paper in the journal of index investing

titled "With Greater Uncertainty Comes Greater Volatility."

The authors found

that the US economic policy uncertainty index,

seems to spike around tight presidential elections

like 2000, 2004 and 2016.

And that stock market volatility

seems to be linked to both economic policy uncertainty

and the business cycle.

So far we have seen that short-term stock market returns

do not tend to be dramatically affected

by election outcomes.

But stock market volatility might increase

with the type of economic policy uncertainty

that arises from tight elections.

A more interesting question might be how the political party

in power affects the stock market returns

throughout the duration of presidential terms.

Forget about short-term volatility.

Is there a longer term difference

in US stock market outcomes related to politics?

In fact there is.

In a 2003 paper in the journal of finance

titled "The Presidential Puzzle

Political Cycles And The Stock Market"

author Santa Clara and Valkanov,

examined the stock market through political cycles

from 1927 through the end of 1998.

Similar to what we have already discussed,

they found no significant evidence

of stock price changes immediately before,

during or immediately after elections.

Interestingly, this finding is consistent

with the finding of a 1989 paper,

titled "What Moves Stock Prices,"

which found that important news

does not tend to be related to large stock market returns.

Santa Clara and Valkanov did find however,

that stock markets delivered much higher returns on average

when Democrats were in power.

The excess return of the US stock market

over three month treasury bills

was on average 9% per year higher,

under Democrats than it was under Republicans

in their sample.

They observed a monotonic increase

in this effect with company size.

The largest firms had an excess return of 7%,

increasing to 22% per year for the smallest firms.

The authors referred to this as a puzzle,

because the difference in returns was not explained

by business cycle variables

and was not concentrated around election dates.

Before jumping to the conclusion

that there is a causal relationship

between positive stock market outcomes

and democratic leadership.

There is a more theoretically consistent

explanation to consider.

In a 2017 paper titled "Political Cycles And Stock Returns,"

authors Pastor and Veronesi,

update and respond to the ideas

in the presidential puzzle paper.

Updating the analysis of stock returns

under democratic and Republican leadership

from 1927 through the end of 2015,

they find that the excess return under Democrats

is 11% higher per year than it is under Republicans

over the full period.

In fact, they found that all of the equity premium

over the full period had been earned

under democratic leadership.

They found the relationship to be statistically significant.

This out of sample test

following the original work of Santa Clara and Valkanov,

seemed to confirm that the relationship is real.

A persistent stock market performance difference

based on political leadership

poses a theoretical problem.

For larger stock returns under democratic leadership

to persist based on democratic policy initiatives.

The market would need to be consistently

underestimating their positive economic benefits.

Pastor and Veronesi instead suggest an explanation

that aligns with the irrational stock market.

It is not democratic policy

that results in positive excess returns,

but the timing of when Democrats have been elected,

they develop a model of political cycles

driven by time varying risk aversion.

In their model, when risk aversion is high,

such as during economic crises,

voters are more likely to elect a democratic president

because they demand more social insurance.

When risk aversion is low,

voters are more likely to elect a Republican

because they want to take more business risk.

In the model, risk aversion is higher under Democrats,

resulting in a higher equity risk premium

when Democrats are elected

and therefore a higher average return.

This model explains the presidential puzzle

of higher stock returns when Democrats are in power

with a higher risk premium.

But the higher risk premium is not caused

by the democratic presidency.

Both the higher risk premium

and the democratic presidency

are caused by higher risk aversion

leading up to the election.

Pastor and Veronesi go on to show,

that this finding within their model

matches up well with the empirical literature

on when Democrats are more likely to get elected.

In a 2016 paper in the journal

of financial economics titled 'Time Varying Risk Aversion,"

the authors use survey data to show

that risk aversion surged after the 2008 financial crisis,

even among investors who did not experience losses.

In a 2010 paper titled "Partisan Financial Cycles,"

Jay Lawrence Broz, examined bank crises

and developed countries

and found that left-wing governments

are more likely to be elected after financial crashes.

In 2012 paper in the American political science review

titled "Unemployment And The Democratic

Electoral Advantage," John R Wright

showed that us voters tend to elect Democrats

when unemployment is high.

Anecdotally, the two biggest financial crises

over the past century showed similar results.

In the midst of the great depression in November 1932,

the incumbent Republican president Herbert Hoover,

lost the election to Democrat Franklin Roosevelt,

In November 2008 during the worst of the financial crisis

the incumbent Republican George Bush,

lost the election to Democrat Barack Obama.

John F Kennedy was elected in 1960

during the 1960, 61 recession.

Jimmy Carter was elected in 1976,

shortly after the 1973, 75 recession.

Bill Clinton was elected in 1992,

after the 1990, 91 recession.

In all of these cases, elections took place

when voters were likely to be more risk averse than usual.

Pastor and Veronesi argued that this is not a coincidence

as described by their model relating risk aversion

to election outcomes.

All of that was a long

and hopefully interesting way of saying

that well there have been statistically reliable differences

in stock returns under different political party leadership.

It is reasonable and theoretically consistent,

to believe that these differences do not result

from the political party leadership.

Rather the political party leadership,

results from the same conditions

that have led to historically higher stock returns.

In other words,

the stock market is going to do what it's going to do.

But the economic conditions

that lead to higher risk aversion

and therefore higher expected stock returns,

also tend to result in democratic leadership being voted in.

I'm not predicting an election outcome

or a stock market outcome based on this information.

And it's anybody's guess

whether the relationship will persist in the future.

Stock market out performance under democratic leadership

is an empirical fact that can be reasonably explained

by the level of risk aversion

at the times when Democrats tend to get elected.

None of this is useful in timing the market.

Risk premium show up quickly and unexpectedly

regardless of the political cycle.

You have to be there to capture them,

which means staying invested.

As we approach this year's election,

it is important to remember

that in the short term,

election outcomes have not historically

had any meaningful relationship with stock market returns.

Tight elections, like we saw in 2016 and 2000,

have resulted in some increased volatility

as the market prices in economic policy uncertainty.

But it has all come out in the wash pretty quickly.

Longer-term while there seems to be a positive correlation

between democratic leadership and stock market returns,

the causal relationship is much more likely

between risk aversion and Democrats being elected.

Also resulting in a higher equity risk premium

over those periods.

At the end of the day,

the equity risk premium has been persistent through time

for those who have stayed invested to capture it.

Thanks for watching, my name is Ben Felix,

and this is Common Sense Investing.

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