"We do not have government by the majority. We have government by the majority who participate." - Thomas Jefferson
Quite a few ‘old adages’ regarding the intersection of markets and politics are plainly and demonstrably false. For example, do you think markets do better under Republican or Democratic presidential administrations? Most Wall Street types, usually well-versed in Milton Friedman, would quickly answer that Republicans, embracing free-market principles and a low-tax bent, would result in higher-flying markets.
This would be incorrect. In fact, since 1900, markets have performed better when Democrats controlled the White House. Facts often run counter to what ‘prevailing wisdom’ would indicate. The prevailing wisdom is most often overrated.
Market volatility is often misunderstood and treated almost with a veil of superstition that can make truth elusive. There are many ways we orient ourselves in the market.
We can examine where we are in the economic cycle to determine which sections of the market can outperform.
We can check historical data and seasonality to inform our forecasts.
We can use discounted cash flows to nail down an intrinsic value.
One analytical method that is often effective is pairing seasonality with specificity. For example, determining the seasonality of volatility in election years versus that in non-election years can be informative. There is a typical pattern to election-year volatility, where the market prices for extra volatility in the runup to the election.
As you can see, the curve is partially inverted around October because of the heightened chances for volatility associated with a contested election, political violence, or other adverse outcomes. However, the tendency is for the runup in volatility to blow off steam once the event has passed, and this year will likely follow a similar pattern despite passions and uncertainty running high. That blip in volatility in October can be profitable to short if historical odds are any indication.
I love what my former boss, Tom Lee of Fundstrat, said about elections and markets. I am not quoting him verbatim, but essentially, the elections are like Thanksgiving and football. Everyone will be talking about it, but you'll be eating good or bad food at the end of the day, regardless of what happens in the game. Markets always price for increased volatility around the election, but it rarely manifests. Even in the last cycle, with a contested election, the market rallied after election day.
When you zoom in on the volatility for the entire election year, the results are similarly counterintuitive to our opening example. Every period except for 12 months before the vote and one month before the vote experienced relatively less volatility in an election year than in other years.
We can see what will likely happen to the inverted VIX curve in October based on what just happened to an equivalent of the VIX on European stocks. Hugely consequential and highly uncertain elections just passed in France. Of course, volatility ran up, and the curve inverted approaching the election, and then after the result, things normalized. You can see European volatility is still inverted around our elections, but the inversion associated with their elections has reversed.
It is not unreasonable to assume something similar will happen with the upcoming election despite all the uncertainty and emotionality. It is important to remember that the market sees things blindly without consideration for our human experience and emotions. The odds are that shorting October volatility as the election approaches will be a good trade. I will provide such a trade as we get closer to November, but the time is not yet right.
Many risks could derail the typical historical patterns. This is not a typical election, and the recent assassination attempt of former President Trump suggests a heightened potential for political violence. History is always a guide that must be paired with the present idiosyncracies to be an effective tool in navigating markets.
Conclusion: What Stocks Can Tell Us About Election Outcomes
The average gain for the DJIA since 1900 has been about 4.8% a year, regardless of what political party was in power; in other words, as long as the American economy is humming and growing, the markets tend to go up regardless of month-to-month, even year-to-year, political outcomes. Stocks have generally been a good investment over time as long as you pick the right ones. Many stocks will eventually go to zero, more than most people think, so do not pick indiscriminately.
One piece of data that may be useful for some investors but is still not a ‘sure thing’ given the high levels of uncertainty in our world is that the market performance in the three months running up to the Presidential Elections does appear to be correlated to the outcome. The incumbents tend to win when the market goes up in the preceding three months, and the challengers tend to win if it goes down in the three months before the first Tuesday in November.
This rule has been predictive since 1928, except for 1956, 1968, and 1980. So, paying attention to economic conditions and the stock market in the coming months will be important. Consumer confidence and wages outpacing inflation should be positive economically, but seasonal volatility is taking off.
Similarly, post-election volatility tends to vary based on whether the incumbent or the challenger wins. In cases when the incumbent loses, volatility significantly spikes relative to when the incumbent wins in the months following the election. These historical facts about markets and volatility are not set in stone by any means. Still, they help us understand volatility and elections more objectively and can result in more accurate forecasts.
Overall, volatility will likely experience a steep dropoff following the election. While it is normal for the volatility of the month before the election to be elevated, it is also normal for implied volatility to experience a crush after the election occurs, even if the outcomes are emotionally riveting like they were in 2020.
