Part 1: Do Election Results Really Matter to Investors?
By and large, the average investor, and a not insignificant number of experienced investors too I might add, has historically responded to uncertainty – market uncertainty, geo-political uncertainty, and the uncertainty that comes from globally-reaching major events like the Covid-19 pandemic – with short-term, emotionally-driven decision making.
You wouldn’t need to take any more than a cursory glance at the market performance data in the months immediately before and after any United States Presidential election over the past century to see what that emotionally-driven decision making can do to markets.
That particular vein of analysis is a path well-traveled by economists and market analysts, and probably doesn’t need my voice added to the fray. Uncertainty leads to panic, panic leads to volatility, volatility leads to more panic, and so on and so on, until the votes are tallied, the decision is made, and everything returns back to (relative) normal – at least until the midterms.
So, as we gear up for yet another highly contentious, emotionally-charged election, I find myself asking, how much does the U.S. Presidential election actually matter to investors? Setting aside the short-term volatility in the build-up and aftermath to the eventual result, to the average investor, does it really matter if there is a Democratic or Republican President?
The short answer, according to a dearth of economists and academics who have spent decades researching this very question, is a resounding, maybe?
The longer answer is perhaps a bit more complex.
The first, and most obvious question, is how much, or how little, it really matters if there is a Democrat or Republican in the Oval Office. Again, to uncover the real answer to this question, you have to peel back the layers a bit and take a closer look at the factors that live behind the bare economic data.
The Princeton Economics professorial duo of Mark W. Watson and Alan S. Blinder (also a former Vice Chair of the Federal Reserve), found that according to virtually all valuable measures of economic activity, the economy has performed better under Democratic Presidents than Republicans since World War II. The data shows that in that time period, average GDP growth rates are 1.8% higher with a Democrat in office.1
Another professorial duo, Pedro Santa-Clara and Rossen Valkanov of UCLA, found that, contrary to the age-old belief that Republicans are “better for business” than Democrats, average excess stock market returns are higher under Democratic Presidents, by as much as 9% in the CRSP Value-Weighted portfolio. The differences in performance are even more noticeable with small firms, who see 22% higher returns under Democratic Presidents. Even large firms still see 7% higher excess returns.2
These same findings are also corroborated in a separate piece of economic research conducted by Professors Lubos Pastor and Pietro Veronesi of the University of Chicago.3
So, there you have it: it’s better for investors if a Democrat wins the Presidential election, right? That’s the bare economic data perspective. The waters get significantly muddier when you ask why.
While all three of these papers have come to the same conclusion through different channels of enquiry, there does appear to be a somewhat unified consensus between them all, mainly, that the economic and market performance data alone is not enough to say that, despite better performance, a Democratic President is better for investors than a Republican.
Watson and Blinder, for example, found that Economic outperformance under Democratic governments was as much a result of external economic factors, including oil prices, productivity growth, and optimistic consumer expectations, as any direct policy measures enacted by the President. As they conclude, “our empirical analysis does not attribute any of the partisan growth gap to fiscal or monetary policy.”
Santa-Clara and Valkanov similarly found that, while certain policies and measures, especially related to capital gains and corporate tax rates, social security spending, and other fiscal policies, maybe have some impact on markets, when they attempted to control against all of those partisan factors, the data still showed Democratic outperformance. Their conclusion, which they agreed would certainly need further exploration in the future, was that perhaps the issue is that economists have long insisted on assuming that markets and investors behave rationally, and that these performance disparities may well come from softer factors, such as the expectations that people form about the economy depending on who is in power, and how those expectations shape their decision making, both in the voting booth, and with their portfolios.
Lastly, Pastor and Veronesi developed a mathematical model to uncover the source of this Democratic outperformance. Again, like the above-mentioned studies, their models showed that specific policy decisions were not the main factor behind the disparities in performance. Their research showed that it was more a matter of timing and relative risk aversion levels than anything else. Democrats tend to be elected during periods of higher risk aversion, which results in higher equity risk premiums, while Republicans tend to be elected during lower risk averse periods, which result in lower expected returns.
Interestingly, all three of these studies seem to point to a similar conclusion: when it comes to the relationship between U.S. Presidential Elections and the economy, we may well be looking at it backwards. That is to say, their analysis does appear to suggest that we should be asking how economic cycles impact election cycles, not the other way around.
These conclusions do of course raise a new, perhaps more important question: if who the President is doesn’t necessarily impact markets as much as we may have thought, what exactly should investors be looking at when making investment decisions during an election cycle?
For the answers to that question, you’ll have to check out Part 2: Investing in an Election Cycle
1. “Presidents and the U.S. Economy: An Econometric Exploration,” Alan S. Blinder and Mark W. Watson, American Economic Review 2016, 106(4): 1015-1045
2. “Political Cycles and the Stock Market,” Pedro Santa-Clara and Rossen Valkanov, The Anderson School, University of California, Los Angeles, October 2000
3. “Political Cycles and Stock Returns,” Lubos Pastor and Pietro Veronesi, National Bureau of Economic Research, February 2017, revised May 2019