On the heels of Super Tuesday, we will know which candidates are likely to emerge as the Democratic and Republican presidential nominees. Whether its Donald Trump and Hillary Clinton, as many pundits suspect, election years have had major implications on the market. This relationship has been the basis for research into how the market reacts in and following an election year.
Over the past 100 years, experts have found that the stock market has performed better under a Democratic President. The Dow Jones Industrial Average has generated average returns of 82.7% under a Democratic president, significantly higher than the 44.8% average returns under a Republican leader.
In the election year itself, the market tends to fall, especially in the final year of a president’s second term. That said, these aren’t hard and fast rules, and history is not indicative of future returns. There is a chance that this year won’t end up as badly depending on who investors think will win the election.
The relationship between presidential elections and the stock market has been a hot button topic for years. The Presidential Election Cycle theory, developed by Yale Hirsch, found that the markets were strongest in the third year of a presidency. On average, the S&P 500 saw 17.5% gains in the third year of a president’s first term and 11.5% returns during the second term. That’s not to say year 3 is always the best, as witnessed by the catastrophe of the 2008 Financial Crisis.
On the other hand, volatility tends to develop in the first year following an election, as the market digests change, and then gradually increases to its peak in the second year of the cycle. During this time, the market tends to generate minimal returns, especially during a president’s first term. In the run up to the election, returns tend to move sideways as a reflection of greater future uncertainty. In the final year of an election cycle, average market returns were 6.1%, falling to negative territory during a president’s final term.
Overall, only 5 presidents in history have seen equities rise more than 50% during their term. The exclusive club includes recent Democratic leaders, Bill Clinton and Barack Obama. Meanwhile, Herbert Hoover and Richard Nixon saw the biggest drop-offs in presidential history largely due to the Great Depression and Watergate Scandal, respectively.
Another caveat to this relationship has been how global equity markets react to the U.S. election cycle. Typically, global markets exhibit similar patterns as domestic ones, with lower returns in the second year of the cycle and declining volatility thereafter. The election cycle explains a sizable portion of global equity returns both in developed and emerging markets.
Meanwhile, the market has been somewhat of a leading indicator for elections with an incumbent candidate. As you would suspect, when the market makes significant gains, the incumbent usually wins re-election in a landslide. This is fairly intuitive, since a bull market is indicative of a booming economy supported by sound policies.
On a more granular level, you can often figure out who will be elected based on the 3 month returns of the S&P 500 preceding an election. A rise in the index between July and October of an election year has predicted reelection of the incumbent candidate or party, while the reverse has pointed to a replacement.
Regardless of how remarkable the correlation between election cycles and the stock market sounds, it should not dictate your investment decisions. The patterns in the relationship are often viewed as spurious with no direct causal connection. Instead your behaviors should follow the basic fundamentals of investing such as understanding risk, diversification and market timing.