Part 2: Investing in an Election Cycle
If you read Part 1 of this broader piece focusing on the upcoming U.S. Presidential Election, you’ll recall a few important pieces of information and analysis that have significant bearing on the investment landscape for the next several months, maybe even longer.
To summarize, election cycles create uncertainty in the markets, which creates a period of volatility both before and after the actual election. Further, there is some intriguing economic research that shows that there isn’t any real, definitive answer as to whether it’s better for markets or the economy if a Democrat or a Republican sits in the oval office, and that by and large external economic factors have a much larger impact on investors than the President themselves.
That left us with one, rather large question: what exactly should investors be looking at when making investment decisions during an election cycle?
Again, as in Part 1, there is a short answer, and a longer, more complicated answer. The short answer is that the best way to invest in an election cycle is most likely to stay the course with your chosen strategy, avoid panic trading, and stick to the fundamental factors that have driven your long-term investment approach leading up to this point. The short answer is also the boring answer that you are likely to get from just about any investment advisor worth their salt.
So, for the sake of not being boring or repetitive, let’s explore the long answer, which warrants breaking down into a few different parts:
Party policies and and legislative measures
Government status
Probabilities and portfolio construction
First, let’s look at the most obvious part, or at least, the part that tends to consume the vast majority of the discourse around investing in election cycles: who wins.
As I found in Part 1, historical economic data says that a Democratic President is better for the economy and markets than a Republican, but that data doesn’t tell the whole story. Of course, looking only at the other external factors discussed in those studies also doesn’t tell the whole story. What we’re left with is a bit of a stalemate, where we can’t say definitively if it does, or doesn’t matter who sits in the oval office.
But, from an investors perspective, there are certain things that will bear some relevance to your investment strategy that will differ from a Democratic or Republican Presidency. Where does each candidate stand on matters or values that are important to you and your investment approach? How could their foreign policies affect your investments outside of the U.S., or even those inside the country? Will their policies around taxation and social security change your end-goals, and what do you need to do to adjust? How do their values impact your own in terms of ESG and sustainable investing?
All of these are questions which, while they may not have an oversized impact on markets at large (though, they also could), will potentially have a significant impact on your own portfolio, and warrant a considerable amount of thought and attention in the build up and aftermath of an election cycle.
Next, let’s look at election results outside of the Presidential Election. In many ways, the make-up of Congress and the Senate have as much, or more, impact on markets than the Presidency.
For some analysis on this question, I’ll turn to an intriguing piece of research conducted by Theofanis Papamichalis (Cambridge), Dean Ryu (Oxford and Harvard), and Mungo Wilson (Oxford) on the impact of the status of governments on stock markets.1
In their study, they explored the different stock market outcomes depending on whether the sitting government is united (meaning the same party controls the White House, Congress and Senate) or divided (meaning the different parties divide control between the three institutions). What they found was that, contrary to the age-old adage that “gridlock is good,” united governments stock markets perform better, and the economy experiences stronger growth than during divided governments.
In fact, what they call the “government gap,” or, the disparity in economic and stock market outputs during a united or divided government, is significant across value-weighted (8.7% difference) and equally weighted portfolios (16.8% difference), as well as overall GDP growth (2.5% difference).
Interestingly, they also found that the “government gap” is more notable during Republican Presidencies than Democratic ones. With a Democrat in the oval office, the government status (ie. united vs. divided) had no discernible impact on equity premiums. However, Republican Presidents with a united government were able to achieve stock market performance that exceeded Democratic Presidents with either united, or divided governments, but Republican Presidents facing a divided government saw, quote, “dismal” stock market performance.
All of this goes to show that, historically, the best outcome for the stock market in terms of an election result is a Republican President, with a Republican-controlled House and Senate - but again, that doesn’t tell the full story, nor is it particularly helpful for you to make decisions about your portfolio.
A related study by Kam Fong Chan (University of Queensland Business School) and Terry Marsh (U.C. Berkeley), which explored the shifts in uncertainty and equity premiums over the entire election cycle, found that U.S. equity premiums are significantly higher (2.5-4%) in the months immediately following a midterm election than at any other point in the election cycle. They attributed this phenomenon to the fact that political uncertainty (as measured by the Economic Policy Uncertainty index) is at its highest in the build up to midterm elections, meaning when that uncertainty eases, it tends to be a tail risk that has historically resulted in higher premiums.2
So, again, we have a set of historical data, with an intriguing and insightful analysis that gives a significant amount of context, and just as many questions about what to actually do with that information. This brings us to the question of portfolio construction and probabilities which, hopefully, will feel more actionable from an investment perspective than what I have discussed up to this point.
This is where probabilities come into play. Essentially, you have to find some way to account for the probability of anything and everything happening, and creating a portfolio that is positioned to take advantage of the potential risks and rewards of those probabilities.
There’s a relatively simple way to do this, and a much harder way with a significantly different risk/reward profile. The simple way would be to take the market equilibrium approach, and build your portfolio to be more or less in line with the general makeup of the markets.
As a simple example, if the markets are 40% international and 60% U.S., that is functionally the consensus prediction for where markets are going to go. If you’re happy with a strategy that can broadly be described as solid, if not overly exciting (which is not a bad thing), then following the market consensus could serve you well. If you are willing to take on a little more risk, for potentially more reward, you can take the consensus as a starting point, and start to weave in your own predictions from there.
So, back to the question of how to invest in an election cycle then. There’s the safe, time-tested approach of “wait and see” and avoiding getting sucked into any panic buying and selling. That may well work for you, and it probably won’t create new risks in your portfolio over the long term.
Then, there’s the “probabilities” approach, where you take the baseline (the markets), and start to make small tweaks to your portfolio based on, in your view, the probabilities of each possible election outcome, and what they mean for the markets. This approach is not unlike using a Black-Litterman Model.
Being successful as an investor is equal parts deeply technical predictive modeling, educated guessing, and sometimes, sheer dumb luck.
So, how do you invest in an election cycle? It would take a bold person to predict the outcome of this particular Presidential election, so in reality, there’s no single right or wrong answer to that question.
1. “Divided Government and the Stock Market,” Theofanis Papamichalis, Dean Ryu and Mungo Wilson, November 2022
2. “Equity premiums in the Presidential cycle: The midterm election resolution of uncertainty,” Kam Fong Chan and Terry Marsh, April 2018