Mixing Politics and Money – A Sure Thing?
Unpacking the relationship between elections and markets. Should you invest accordingly?
With the 2018 midterm elections rapidly approaching, politicians are shifting their campaign machines into gear. The energy surrounding the races will likely continue to build and then crescendo on Election Day, Nov. 6. At the national level, the focus this year is on the Senate and House of Representatives. With Republicans in control of the executive and both legislative bodies, voters will decide whether that unified control will continue for another two years.
Common wisdom suggests U.S. stocks have performed better under divided government, when at least one legislative body – the Senate or the House – is controlled by the party opposite the president’s. With that in mind, should those motivated solely by anticipated equity returns cast votes for the Democrats, regardless of their political beliefs? Should investment decisions take these factors into account?
According to a 2012 paper, "What to Expect When You're Electing," equity investors have no reason to hope for a divided government. The study examined monthly observations of annualized returns between January 1965 and December 2008. Large stocks' average annual return was virtually the same during the 33 percent of months of political harmony – when the same party controlled the presidency and both legislative branches – and during the 67 percent of months of gridlock. Contrary to that sentiment, the small stocks' average annual returns were 21.2 percent higher during periods of harmony than periods of gridlock. The opposite was true for bonds, as corporate and Treasury bonds’ average annual returns during times of gridlock exceeded the returns of harmonious periods by 8.6 percent and 1.3 percent, respectively.
Aside from disputing the "markets love gridlock" theory, research also supports some shared beliefs about relationships between politics and historical market returns. For instance, the study’s results were consistent with the popular theory that equity markets perform better with Democrats in the White House than Republicans. Like the harmony/gridlock observations, the magnitude of small stocks’ average annual out-performance during Democratic presidencies was especially notable at 16.7 percent. Small stock out-performance was statistically significant while the large cap stock average annual out-performance of 6.9 percent was not. Again, corporate bond performance showed the opposite correlation, returning 7.2 percent more with Republican presidents in office than Democrats. However, Treasury performance was essentially the same under Republicans and Democrats.
Another observation: Historically, stocks have performed better in the third year of a president’s term than any of the other three. According to the study, large cap stock annual returns were 17 percent higher on average during the third year of each presidential term than the other three years, and small stock returns were 26.9 percent higher. Both of these were statistically significant as well.
Along with these relationships between elections and markets, the study also revealed that another part of the government – the Federal Reserve – might be just as important. Some have contended the Fed’s monetary policy is more important to the markets than electoral politics. In an effort to disambiguate the impact of politics from monetary policy, the researchers examined the relationship between stock returns and these two variables jointly, rather than separately.
According to the study, monetary policy had more statistical explanatory power than the president’s political affiliation during the 53-year observation period. Average annual large cap stock returns during periods of expansionary monetary policy exceeded those during periods of restrictive monetary policy by 11.7 percent, and small stock returns were 25.6 percent higher.
Overall, the only statistically significant relationship for large stocks was the stronger average performance during the third year of the president’s term. Small stocks’ returns, on the other hand, had statistically significant relationships with three variables, outperforming during the third year of presidential terms, periods of political harmony and periods of expansionary monetary policy.
Despite these findings, however, investors should keep in mind the old adage about the person who was six-feet-tall yet drowned crossing a river with an average depth of just six inches. It may have been six inches on average, but it was dangerously deeper in just the wrong place.
The third years of both of President Barack Obama’s terms demonstrate this point.
Large stocks returned 23.1 percent on average during the third year of presidential terms between 1965 and 2008; in 2011, they returned 2.1 percent and in 2015 they returned 1.4 percent. Those were the two worst years for large cap stocks during the eight years Obama was in office, during which the S&P 500’s average annual return was nearly 20 percent.
Though interesting, these data are inadequate bases for making long-term investment decisions. The equity market results during Obama’s third years shows averages and tendencies may belie big exceptions.
Another reason is that predicting election outcomes can be very difficult, as the Brexit vote and 2016 U.S. presidential election illustrate. Besides, different factors in the study can yield mixed signals. If one were considering how to invest now, for instance, unified government would be a positive signal for stocks, being in the second year of President Donald Trump’s term would be neutral, at best, and increasingly restrictive monetary policy would be negative.
Although attempting to time the markets can be alluring, instead consider the time-tested approach: Constructing a diversified portfolio based on one’s risk tolerance and return objective and then rebalancing periodically. A program of appropriate asset allocation, diversification, and rebalancing is more important for long-term investing success than following the election cycle.
Chris Meyer is the vice president of Innovest Portfolio Solutions, an innovative investment solution for endowments, foundations, retirement plans and families.