Occam’s – How Do Presidential Elections Affect the Markets?

WHAT IS OCCAM’S RAZOR?
Occam’s Razor is a principle attributed to William Occam, a 14th century philosopher. He stressed that explanations must not be multiplied beyond what is necessary. Thus, Occam’s Razor is a term used to “shave off” or dismiss superfluous explanations for a given event. This concept is largely ignored within the investment management landscape. This newsletter will “shave off ” popular investment misinformation and present what is important for achieving long-term investment success.

How Do Presidential Elections Affect the Markets?

With the presidential election coming up, people are naturally curious about what the elections mean for the stock market – and, more importantly, for their investments (and everything those investments represent). Answers to this question run the gamut depending on where you get your news, so I wanted to break down the data and see what actually happens during and after an election.

Most people approach questions like these from a partisan perspective (“Here’s why my team is better than yours”), but I’m not interested in that. I want to look at this from a purely analytical perspective and let the data drive the results. There are enough folks out there torturing the numbers to get the answers they want. I want to see what the numbers tell us.

I’m asking two questions here:

  • Does the party that wins the election matter to the stock market?
  • Does a presidential campaign impact stock returns?

In other words, should I be worried now, and should I be worried in the future? The short answers are that having a Democrat in the White House seems to correspond to higher stock returns (though so do left-handed and tall presidents), and stock returns during campaign season seem to bounce around more than during other times.

Does Political Party Matter to the Stock Market?

Looking at the impact of elections through political party is pretty reductionist – did Harry Truman and Bill Clinton have the same views on the economy? Did Dwight Eisenhower and George Bush (either one) govern the same way? Every president approaches the issues of the day in his own way, and while the issues have some overlap, they have largely varied for each president.

Judging market responses by political parties does have one advantage: candidates are (kind of) consistent with regards to where on the political spectrum they are. If I say someone is a Democrat, you can fairly confidently assume they fall somewhere left of center.

On top of that, politics is a team sport. Everyone claims their team is better, so every four years we see a bunch of stories about how the markets do better/worse when a Democrat/Republican is president.

Everyone focuses on the presidency, but what about Congress?

Let’s look at the data. For the course of this analysis, we’ll be looking at the US stock market, for which we will use the CRSP 1-10 Index as our proxy. The CRSP index is the best representation of the US market – it includes pretty much every stock that trades in the US. Plus, we have data going all the way back to 1926. Because we’re looking at something that only happens once every four years, we need all of the data we can get our hands on. So for this analysis, we’ll be looking at the CRSP 1-10 for the period from the beginning of 1926 until the end of 2015.

I also want to mention how we will be looking at the data. Typically, when we talk about investment returns, we include annualized returns and standard deviations. For this, we’re going to use a slightly different approach. We’ll still look at standard deviation, which is a measure of how much an investment bounces around, but we’ll be looking at annual average returns instead of annualized returns. This may seem like a small change, but it’s important to understand.

We normally use annualized returns because they are easier to conceptualize – they essentially smooth out the bumps and let you compare “effective returns” through time. That’s great for day-to-day use, but the smoothing comes at a cost. It is incredibly difficult to run tests of statistical significance on annualized returns, which is exactly what we want to do here. We want to see if return differences are from chance or if something is actually going on here. Average returns allow us to do that.

First off, the market seems to do better when the Democrats have the White House.

Average Annual Return Standard Deviation Number of Years
Democratic President 15.08% 17.32% 48
Republican President 7.88% 22.38% 42

 

This is a pretty big difference – about 7% per year – and it is statistically significant.[1] There’s only a 0.02% chance this difference is just luck of the draw.[2] One of the objections often raised to this is that the president’s policies and actions don’t immediately go into effect, so the Democratic presidents are getting all the credit for their predecessor’s work. It is undoubtedly true that seeing results takes time, so let’s add in a one-year lag. In other words, the previous president gets credit for the first year of the next president’s tenure. Does the premium go away?

CRSP 1-10 Index Average Annual Return Standard Deviation Number of Years[3]
Democratic President 12.36% 16.95% 47
Republican President 11.02% 23.17% 43

 

The average returns for Democratic presidents are still higher, but the premium shrinks considerably. That being said, the difference between Republicans and Democrats is still statistically significant – there’s only a 1.89% chance that there is no “real” difference between average returns. It’s also worth noting that the difference between the raw and lagged returns for both Democratic and Republican presidents is not statistically significant, so a significant lag in the effects a President has on the markets is unlikely.

So yes, a Democratic president seems to result in higher stock returns. But what if we look at control of the House?

Average Annual Return Standard Deviation Number of Years
Democratic House 11.54% 20.17% 64
Republican House 12.17% 20.17% 26

 

A Republican-led House actually led to a higher average return than when Democrats had the majority. However, this difference is not statistically significant, so it could be pure chance. How about the Senate?

Average Annual Return Standard Deviation Number of Years
Democratic Senate 12.71% 19.26% 60
Republican Senate 10.48% 21.79% 29

 

The Senate is pretty much the same story as the House. The difference between the two average returns is not enough to be statistically significant.

But what happens when we look at different mixes of party rule between the executive and legislative branches?

Average Annual Return Standard Deviation Number of Years
Unified Democrat 15.07% 18.21% 35
Democratic President and Senate, Republican House 15.94% 14.36% 4
Democratic President, Republican House and Senate 14.76% 16.61% 9
Unified Republican 9.22% 24.34% 13
Republican President and Senate, Democratic House 5.01% 23.97% 8
Republican President, Democratic House and Senate 8.15% 21.58% 21

(You might notice that this chart doesn’t include any period where one party controlled the presidency and the House, but not the Senate. That’s actually never happened. The Senate has always lined up with one or the other.)

Looking at the data, there seems to be something the market likes about a Democratic president. Other than that, it’s pretty hard to draw any conclusions – especially considering the small number of observations we have with some of these scenarios. That being said, this is definitely good party trivia.

So based solely on this data, the key to higher returns is to vote for the Democrat in November. However, this is a pretty simplistic analysis. The stock market is massively complex, and teasing out causation would be incredibly difficult. There may well be something about having a Democrat in office that helps the markets, or it could be outside factors, or some combination thereof. On the other hand, looking at the numbers, the candidates’ height matters more than their party.

Average Annual Return Standard Deviation Number of Years
Presidents 6’ and Over 15.65% 17.44% 48
Presidents Under 6’ 7.23% 22.04% 42

 

Not only is the gap between the average annual returns for tall and short presidents (8.42%) greater than the difference between Republican and Democratic presidents (7.20%), but there is even less chance that the difference between tall and short presidents is based on chance.[4] Looking at the four major candidates this year, both Cruz and Clinton are under six feet, Trump is taller than six feet, and Sanders is right about six feet.

We might also want to look at which hand the candidates write with – left-handed presidents had better stock market returns. The difference isn’t quite as big as height or party, but it’s nearly as unlikely to be random.[5] Unfortunately, all of the candidates this time around are right-handed.

Now, how tall the president is or which hand they write with probably doesn’t actually make a difference, but it’s a good lesson in the limits of statistics. There’s no particular reason tall or left-handed presidents would be better for the stock market. Statistics can only describe what happened. They say nothing about causation. When we find a relationship, it’s up to us to look at it and decide if the relationship is meaningful – is this cause and effect or mere happenstance?

Figuring out which relationships are meaningful is actually one of the biggest challenges in finance. Everyone is working with the same dataset (market returns) and trying to find new relationships. It’s easy to find relationships that aren’t there. Given an hour with the data, anyone could find five new statistically significant relationships connecting things like presidential facial hair or birthplace to market returns, but that doesn’t mean one is a result of the other.

The field of statistics is based on probability, so if you tested a bunch of relationships, there’s a decent chance one would look like it’s not just chance.[6] But those relationships are very unlikely to be meaningful – they exist in the data, but they probably won’t persist going forward.

Maybe there is something about Democrats as president that helps stock market returns, but the causal argument is going to be pretty hard to make. Regardless, half of the country will disagree with you no matter what you say.

But what about campaigns? Even if there is no clear answer on how the results of an election will affect the stock market, what happens during the campaign?

Noise and Thunder Signifying Nothing

Presidential campaigns cause a lot of noise. That’s pretty much true no matter how you look at it. Just like presidential candidates, the markets are always looking to the future.

Markets move on expectations and new information. In other words, they are constantly reacting to what is happening now and how the market thinks current events will affect future events.

Presidential campaigns are full of new information—some scandal or triumph occurs, or a candidate gives a particularly stirring speech or changes a stance. As you can imagine, all this new information causes the markets to jump around more than usual.

And it doesn’t even particularly matter if what the candidates are saying would result in good policy or not. It’s new information. How the market reacts to this new information will vary, but the market will move simply because new information crops up. However, it’s important to remember that the defining feature of a campaign is uncertainty. Except in rare circumstances, no one (including the market) knows who will win or which set of policies the new president will (try to) implement.

First off, there doesn’t seem to be any real change in the market’s expected returns during a campaign. If we compare the returns of the US stock market during presidential election years to the average year, election years have a slightly lower average annual return (10.99% vs. 11.72%), but, again, that’s not a statistically significant difference. There’s so much variability in stock returns that we can’t tell if this difference is random noise or not. If we look at presidential election years versus non-election years, we get the same story. Election years have a slightly lower average return than non-election years, but it’s nothing to write home about.

What if we narrow it down to just the general election campaign season? For our purposes, I’ve defined the campaign season as being from July through September. When we look at the actual campaign season, the story flips. The campaign season actually has higher average monthly returns than during the same period in non-election years (1.22% vs 0.38%), but the difference is indistinguishable from noise due to the high levels of volatility.

While we can’t say anything about returns during campaigns seasons, there is an interesting result about the amount of volatility in the markets. The standard deviation of the average monthly returns during campaign seasons is greater than the same period in non-election years (6.58% vs 5.76%), and it is statistically significant. This is what we would expect to see – not necessarily higher returns during campaign season, but a definite higher level of uncertainty.

So What Does All of This Mean?

Well, if you’re a long-term investor, it means you don’t really need to worry about how your portfolio will react to the presidential election. There may be a benefit to having a Democrat in the White House, but whether or not there is a causal relationship there is up to your interpretation (and how you answer that question will probably be pretty tightly tied to how you would vote anyway). You don’t need to worry as much about how Congress will impact your portfolio returns – history says they don’t really have much impact on the markets. Overall, your portfolio just doesn’t move all that much based on politics.

If you’re a short-term speculator, you may need to worry. All the uncertainty and stuff (to use a technical term) going on during a campaign equals extra volatility in the markets and no additional expected return to compensate you for that risk. Another reason short-term speculators may need to worry is the fact that short-term speculation just doesn’t work.

For more on what you should be thinking about when you invest, take a look at our ebooks, “Making the Market Work for You” and “A Minimalist’s Guide to Understanding Financial Markets.”

[1] Throughout the article I’m assuming that stock returns are normally distributed, which they are not. However, it’s a decent approximation, and won’t significantly alter the thrust of the analysis.

[2] More precisely, we’re looking at whether there is a statistical difference between the two average annual returns.

[3] You’ll notice that the number of years doesn’t match the non-lagged data. This is because we are getting an extra year of Calvin Coolidge (the Republican president from 1924-1928) at the beginning of the period, and one less year of Barack Obama at the end of the period.

[4] Looking at the difference between tall and short Presidents, there is only a 0.01% chance that the difference is the result of random variance. There is a 0.02% chance that the difference between Republican and Democratic Presidents is random.

[5] The average annual market return during the tenure of a left handed president was 17.39%, while the annual average return when there was a right handed president was 11.63%. The probability that the difference was random was 0.197%.

[6] A good illustration of this can be found here.

 

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