Election years put intense focus on the economy broadly and, as a barometer of economic success, the stock market. Policies and campaign promises often take shape around the perceived health and growth rate of the economy. The stock market therefore has an outsized influence on politics, but do politics influence markets? With a presidential election approaching, are there evidence-based recommendations for investors who may seek to capitalize on existing trends in market behaviors leading to an election, or conversely, seek to mitigate risks ahead of a U.S. presidential election cycle?
Over the decades, various theories have emerged regarding how politics influences the markets. These theories include an assumption that an uptick in market volatility precedes an election, a theory that equity investments perform better during Democratic administrations, and predictions that politically motivated changes in government spending will influence markets.
But are any of these theories dependable enough to predict how the market will react heading into the 2024 U.S. presidential election? Let’s look at each of the scenarios and examine whether or not an investor would have a sound basis to reallocate assets before the election cycle heats up.
The theory of a Democratic equity premium
Many studies have examined market performance relative to the political party in power, primarily focusing on the party that holds the U.S. presidency, though some studies have focused on the House and Senate. The analysis is complex, and there is still no compelling evidence to suggest that investors should make allocation decisions based on the political party in control. However, the majority of evidence points towards some market advantage during a Democratic presidency.
Findings also suggest a potentially higher premium in effect for small-cap stocks compared with large-cap stocks during a Democratic presidency, as well as excess equity returns with a Republican-controlled House and/or a Democratic-controlled Senate.[1] One study of six modern U.S. presidential administrations found that investors tend to rotate into equities during the last two years of a presidential administration, potentially indicating anticipation of presidential cycles creates an equity premium.[2]
Bear in mind that investors seeking to benefit from a political party’s impact on markets will need to make two successful bets: the first bet being the election outcome, and the second bet being a predictable market reaction to the results. This makes allocation decisions ahead of an election risky for seeking excess returns.
However, if investors are already overweight equities, there is some argument to be made that trimming those holdings may be prudent ahead of an election, as the first two years of an administration may not be as favorable for equities, regardless of who wins. This scenario seems familiar, as we’ve experienced it over President Biden’s first term.
Using this information can help bolster decision-making on a limited basis. For instance, if the Democratic candidate emerges as the favorite this cycle, it may be a good time to address any underweight allocation to small-cap stocks; small caps may perform better during a Democratic administration. However, evidence of Democratic small-cap equity premium isn’t sufficient to make outsized bets, and wagering on the election’s winner early in the cycle is often as challenging as trying to time the market.
The theory of heightened volatility
Many investors believe that market volatility increases ahead of an election due to the uncertainty of the election outcome. Proponents of this theory may point to the last election in 2020 when markets did see an increase in volatility. This theory is appealing because, if true, it means that investors can make market bets on rising volatility without trying to guess the election winner.
While this theory may make intuitive sense, there is little long-term evidence to suggest volatility reliably rises ahead of an election, broadly speaking. However, investors seeking to limit volatility in their portfolio may want to consider reducing exposure to companies and sectors that are caught in the political crosshairs. Holdings in the energy sector, for instance, became more volatile ahead of the 2020 election, and may do so again.
The theory of election-driven government spending cycles
Investors often speculate that market trends during election years can be influenced by changes in government spending. This theory suggests that incumbent administrations seeking reelection may increase government spending in the lead-up to an election to stimulate economic growth and bolster their chances of remaining in power. Conversely, newly elected administrations may prioritize more fiscal restraint than promised in campaigns, leading to a decrease in government spending following an election.
The rationale behind this theory lies in the political incentives of elected officials. Incumbents often seek to showcase a strong economy as a reflection of their leadership, which can translate into increased government spending on infrastructure projects, social programs, and other initiatives aimed at stimulating economic activity as elections draw near. By doing so, they hope to create a favorable impression among voters and improve their reelection prospects.
Conversely, newly elected administrations may inherit budgetary constraints or hold differing ideological views on the role of government in the economy. As a result, they may prioritize fiscal discipline and aim to reduce government spending, potentially leading to austerity measures or cuts in certain areas.
While some evidence suggests equities outperform during the second half of a four-year administration, as previously discussed, betting on a government spending cycle in the months leading to an election is unreliable. Government spending decisions can be influenced by a myriad of factors beyond just election cycles, including unpredictable economic shocks (such as the 2008 Financial Crisis and the 2020 COVID-19 pandemic), geopolitical events, and legislative gridlock.
Because of these complexities, investors should approach the government spending cycle theory with caution and consider it as one of many factors influencing market behavior during election years. Diversification, disciplined allocation strategies, and a focus on long-term fundamentals remain the best bet, regardless of political winners and losers.
As the 2024 U.S. presidential election approaches, it is wise for investors to monitor government spending proposals and their potential implications for various sectors of the economy. However, investors should also avoid trading equities based solely on election year theories.
Markets move based on complex economic dynamics. Election years provide useful information for the markets to digest, but it’s unlikely that investors will benefit greatly by betting that a particular candidate will prevail.
[1] Sturm, R. R. (2010). The Effect of Political Party Combinations on Stock Returns. The Journal of Trading, 5(2), 102-09. DOI: 10.3905/JOT.2010.5.2.102
[2] Colón-De-Armas, C. A., & Rodríguez, J. (2016). U.S. Presidential Politics and the Asset Allocation Decisions of Individual Investors. The Journal of Wealth Management, 19(2), 68-72. DOI: 10.3905/jwm.2016.19.2.068
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
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