"It's the economy, stupid." -James Carville
One of the benefits of stock analysis is that it attempts to strip emotion out of evaluation. For example, rather than pick stocks based on whether we believe in a narrative or not, we should pick them based on whether we believe the company can grow its free cash flow or not. There are analytical tools we can use to assist us in this end.
So, when we use the stock market to analyze particularly emotional events like potential political outcomes it can add value and bring an objectivity that is otherwise hard to achieve. The cold power of raw data speaks loudly in a world increasingly defined by polarization and emotional narratives. Common notions are often defied by the data.
Political narratives are among the most emotional of those we regularly encounter. Uncertainty around elections is always elevated in markets. For the first time in modern history, two consecutive Presidents have only made it through one term. One couldn’t achieve re-election and one reluctantly opted out because of intractable concerns about his age.
This may be an anomaly, but it may also reflect the heightened polarization and increasingly emotional tenor of our political discourse. The de-centralization of party fundraising caused by the internet appears to have heightened polarization and heated up rhetoric to apocalyptic pitches on both sides. Respective media machines may be so effective at elevating a President’s negative numbers in his first term, that re-election could become increasingly elusive.
Or the current polarization could reverse as Donald Trump and Joe Biden eventually pass into memory. Political questions such as these are qualitative and are best left to the experts. However, there are very clear questions we can answer with data.
The inferred conclusions of such datapoints are not necessarily what you think they are, but we can determine several relevant, and sometimes predictive, facts about how the stock market and elections affect each other historically. While any piece of historical data serves to inform forecasts and inferred conclusions are not set in stone, it is a more useful input than most.
The first thing we can determine about Presidential elections and the stock market is that the stock market tends to perform better when a Democratic President holds the office since 1900.
· There is no qualitative reasoning for this that we would ascribe to, and it very well could be due to chance.
· Or it could be due to a greater propensity for stimulative spending.
· That question is beyond the scope of our piece today, but it is an interesting question.
Instead of using this piece of information as fodder for political debate, we should simply contemplate what it means for returns. When we assess politics as it applies to our portfolio, we should suspend our personal positions. We should have a contingency plan for either election outcome and we also shouldn’t let our personal political confirmation bias affect our investing.
One example would be separating our personal definition of inflation from the market’s relevant definition. Many people feel the pinch of higher prices and thus think inflation is out of control, and from a personal perspective it may be. However, on a macroeconomic level, inflation is collapsing, and this is allowing the Federal Reserve to cut, which typically allows stocks to rally significantly.
There is now a greater than 95% chance, as inferred by bond markets, that the Federal Reserve will cut rates at its upcoming meeting in September. This tends to be positive for stocks and will alleviate pressure on high valuations.
The second thing we can determine about elections from the stock market is that incumbent parties are likelier to win if the stock market is positive in the months leading up to the elections.
· If the stock market is negative in the months leading up to the election, the challenger party is more likely to win.
· This rule has been predictive since 1928 in every election except for 1956, 1968, and 1980.
So, the next few months and how they play out in the stock market may provide some illumination into who will win the Presidency. And sticking to this emotionless analytical input may provide some objectivity as we approach an emotionally heated election season.
It is in line with James Carville’s oft-cited quote introducing this article that the incumbent performs better when the stock market is doing well going into the election. But diving deeper into the economy things are looking positive for the incumbent. That is because the Federal Reserve has vanquished inflation as a serious threat and will likely cut at the next meeting.
The third major insight we can derive from stock markets is what happens to markets after the election.
· If the incumbent wins, it tends to be a less volatile period.
· If the challenger wins, it tends to be a more volatile period.
· Interestingly, election years have less net volatility than other years.
Since the challenger this year is running on several radical economic proposals like threatening the independence of the Federal Reserve, replacing taxes with tariffs, and significantly devaluing the US dollar the insight seems to check out this year. To some these are radical proposals, to some they are disruptive in a positive way.
But these are all three policies that could potentially have a very adverse effect on US stocks given their novelty. They could ultimately be successful, but they will likely cause bumpiness at some point during their implementation, if it occurs. We don’t place a judgement on them for our purposes, we merely point them out as suggesting a connection between the historically derived rule and what we currently see in our reality. Challengers tend to embrace ideas that shock and disrupt the old regime, regardless of party.
So, it is very important to remind people that historical outcomes can never fully predict the future and we have many unique drivers in this election, as in all elections. Even the most predictive rule we find failed to accurately predict the outcome of the election in three major cycles.
However, there is a tendency to be negative on the economy on Wall Street. Think about it, if Wall Street is positive on everything then what reason do you have for them? The election this year is an unpredictable event that no one currently knows the outcome of. Yet, with a little historical analysis and answering questions objectively, we can dramatically improve our forecasts by understanding how markets and politics converge.
