Two Presidential Candidates Walk into a Bar

“It is a habit of mankind to entrust to careless hope what they long for, and to use sovereign reason to thrust aside what they do not fancy.” – Thucydides

Stop me if you have heard this before: The upcoming election is the most important election in our country’s history. A polarizing divide between candidates and policies means that the decision we make this November will reverberate for generations to come. Simply put, the future of our republic hinges on the outcome.

Such has been the rhetoric of candidates, media pundits, political commercials, and headlines starting in 1792 and repeating every four years thereafter. Whatever represented the 18th and 19th century equivalents of Twitter almost assuredly had “experts” loudly opining on the momentous importance of each election and the potentially grave historical consequences of “poor decisions”. 

This is not to suggest that the 2020 election is more or less historically important than past elections. Maybe this time is different and 2020 is the most important election in history. 

The point here is not to argue the historical significance of this election but to suggest that nearly all of what we so repeatedly consume each election cycle needs to be taken with a big grain of salt. This is no more true than in the purported connections between the election and Wall Street. While there are undeniably consequences to the economy and the stock market stemming from the election results, much of what we are led to believe about this connection is misleading, if not false. To put this in perspective, we outline several of the fictional narratives that – in some fashion – become mainstream thinking every four years. 

Fiction 1: Given the uncertainty surrounding the election, it is a good idea to hold cash and wait until after the election to invest.

Since investment markets move higher over time, this line of thinking inherently presupposes that markets will perform poorly leading up to a presidential election and that the clarity of a winner will then lead markets higher. Fact: the stock market has performed dramatically better in the months leading up to Presidential elections. Not just a little better – dramatically better. The chart below shows the combined return of the S&P 500 in the four months leading up to (presidential) election days starting with the 1928 election compared to the other 44 months of each 4-year election cycle.

Recall the basic formula: stock market value = future corporate profits / uncertainty. The stock market moves higher when one or both of two things happens: the expectation for future corporate profits increases and/or uncertainty decreases. What happens as an election nears? Outcomes become clearer – obviously not 100% clear – but clearer than several months earlier when so much was uncertain. As uncertainty wanes, stocks move higher and investors get compensated for the uncertainty. So, while the natural inclination may be to avoid uncertainty ahead of an election, the economic rewards transfer to those who are willing to assume the uncertainty of investing in advance of known outcomes.   

Fiction 2: Once the election result is known, you should reduce/increase risk if Trump/Biden/Elvis is elected.

Here is an important reminder of how investment markets work: once election results are known, stock and bond prices immediately reflect the result, positive or negative. The market immediately incorporates the future impact of anticipated tax policy and fiscal spending and moves accordingly. Stocks within politically-sensitive sectors like healthcare, defense, and energy instantly adjust up or down based on the election result. There is no free lunch where investors can load up on defense contractor stocks after the elections results are known and expect to be rewarded because Republicans swept the ballot. Any such news will already be factored into stock prices by the time that any of us can trade on the results.  

Unless the election result is a big surprise, the market is likely to have already “baked-in” the anticipated policy of the frontrunner candidate(s) before election day. As a result, the rational justification for trading based on election results is that you can better forecast the impact on global economics than the best institutional investors in the world. Citing investor Allan Roth in the Wall Street Journal, “Extrapolating common knowledge into predictions of the future is really just following the herd, and that typically doesn’t go well.”

Fiction 3: The election result will significantly impact on the stock market over the subsequent four years.

For months leading up to election day, we are inundated with politics, pundits, polls, and partisanship. It saturates the headlines and stories we read, hear, and see. The natural conclusion is that the election result will have a profound impact on the stock market. However, the impact of the election is likely far less impactful on stock and bond markets than we believe. The obsession to so closely link politics and Wall Street is radically misplaced. 

In fact, we make the same mistake of misjudging the impact of a CEO on a business’s performance or a coach on a team’s success. While the CEO, the coach, or the president do have an impact, all the evidence shows that we tend to dramatically overestimate their importance.

What has far more impact on the stock market than the president? Start with Federal Reserve policy. Anyone who is still unclear on why the stock market advanced more than 55% from its March 2020 lows despite a global pandemic and the deleterious economic consequences is likely underselling the impact of 2.3 trillion dollars being added to the economy in April by the Federal Reserve and the follow-up monetary stimulus. Historical data clearly shows that Fed policy has a far more direct and significant impact on the stock market than who sits in the Oval Office.

An additional factor that is considerably more predictive of future investment returns is the value of the stock market on election day. Said differently – the cheapness or richness of stocks on election day offers a far better indication of how the market will behave over the ensuing four years than who wins the election. 

For some validation, consider the S&P 500 cyclically adjusted price/earnings (CAPE) ratio – a useful measure of the stock market’s valuation. We can bifurcate each 4-year presidential cycle based on whether the starting CAPE on election day was above or below the median CAPE. On the left side of the charts below are the presidential terms that began when the stock market was cheap (relative to the median) and on the right side are the presidential terms that began when the stock market was expensive.  

The average annual return for presidents lucky enough to begin their term with cheap stock market valuations (left side): 10.2%. The average for unlucky presidents, elected when stocks were at more expensive valuations (right side): 0.8%¹. 

Fiction 4: Republican presidents are better for the stock market.

The data is very clear to the contrary. Since 1933, the S&P 500 has achieved a 10.2% annual real return with Democrats in the White House compared to a 6.9% real return when Republicans occupy the White House². There are, however, many problems with taking this data and drawing conclusions from it as we will explain further below.

Fiction 5: Democratic presidents are better for the stock market.

Democrats will point to historical data and conclude that stock markets and corporate growth perform better when a Democrat is in the White House. The reality is that this deduction confuses causation and correlation. There is no way to perform a scientific experiment where the economy goes into a laboratory to test for the controlled impact of one element (presidential party). Way too much noise. Outside factors such as changes in oil prices, global monetary policy, terrorist events, natural disasters, asset bubbles, and technological advancements have far more impact on stock prices than presidential policy initiatives. We cannot just strip out the impact of these exogenous factors and view the impact of the presidency. 

Furthermore, the data set is still too limited to draw significant conclusions given that there have been only 8 Republican and 7 Democratic presidents since the inception of the S&P 500 Index. Further to this point, nearly all of the performance advantage for the Democrats can be attributed to the stock market boom under Bill Clinton and the subsequent dot.com meltdown under George W. Bush.  

Fiction 6: A Biden presidency will result in higher corporate taxes and, consequently, be negative for the stock market.

Rather than focusing on the historical stock market record of past presidents, investors are right to be focused on the policy agenda of each candidate and the resulting investment ramifications. Candidate Joe Biden has outlined a plan to reverse the Trump tax cuts for corporations which, if implemented, would hurt corporate profits. Wall Street economists estimate that the proposed corporate tax hikes would reduce 2021 corporate profits by 5-12%.

While accurate in a vacuum, this logic ignores two key factors. First, Biden would need Congressional help to get his proposed tax hikes passed – something that seems unlikely if Republicans retain Senate control. Second, this logic considers only one component of Biden’s policy initiatives. Just as Trump’s foreign trade war had a negative impact on corporate profits that countered the beneficial tax cuts, Biden’s proposed tariff reversals would similarly serve as an offset to corporate tax hikes in regards corporate profits. The same could be said for Biden’s proposed $2 trillion infrastructure spending package which would be kindly welcomed by the stock market (albeit not kindly welcomed by the bond market).

What it all means to you

Here is how November 2020 will play out: On election day or soon thereafter, we will learn the election results. Roughly half the country will be disappointed – if not outright distraught – by these results. Many individuals in this disappointed/distraught camp will look to their investment portfolio as a way to respond. They will make dramatic changes, rationalizing such actions based on steadfast concerns about the direction of the domestic economy, tax policy, foreign trade, government spending, and the leadership of our country. Although the reasoning may seem perfectly rational, these will be emotional, personally biased, knee-jerk responses.

There is clear evidence that our political beliefs and the political climate impact our investment behavior. Citing a comprehensive examination of politics and investment decisions, “Individuals become more optimistic and perceive the markets to be less risky and more undervalued when their own party is in power. These shifts in perceptions of risk and reward affect investors’ portfolio decisions.” Furthermore, the historical data demonstrates that investors “improve their raw portfolio performance when their own party is in power.” This performance advantage comes not because one party is better than the other for stock markets. It comes because investors who stay invested achieve better returns. When investors allow their disappointment with political results to impact investment decisions, the implication is worse investment returns – a double whammy of sorts.   

The best course of action after election day will be to fight back any emotional responses – good or bad – and adhere to the same pre-election long-term discipline. We recognize there will be disappointment with the election result, regardless of who wins, but we are confident that the strict discipline of removing emotion and knee-jerk reactions from investing decisions will prove better in the long run.