Parties Compare Well With Look at Returns (Kerry L. Watkins Commentary)

In the run up to all presidential elections, the popular press is awash with reports about whether Republicans or Democrats are better for the stock market. Right or wrong, lore tells us the market prefers Republicans. Most corporate executives and stock traders are Republicans, and many Republican policies are perceived to be favorable to stock prices and capital formation. Democrats are perceived to be less amenable to favorable tax treatment of capital gains and more in favor of regulation and income redistribution.

There are three popular areas that have been studied in great depth. The “party effect” tests the popular wisdom that over time the stock market prefers Republican presidential administrations.

Another is the “election reaction” which tests the immediate reaction to the election of a Democratic or Republican president. And the third rests on popular wisdom that the last two years of a president’s four-year term feature better stock performance than do the first two years. With the election fast approaching, it’s timely to take a look at the findings.

The party effect is both true and false depending on how you measure it. The greatest bear market in history occurred during the Hoover (Republican) administration and stocks did quite well under Franklin Roosevelt (Democrat). Nominal returns have been better under Democratic rule. When taking into account inflation, which also has been higher under Democratic rule, real returns (after inflation) have been better under Republican administrations for the time period 1888 to 2001, but severely under performed in the post WWII period (1948 to 2001).

The immediate reaction of the market from the day before the election to the day after, dubbed the “election reaction,” does indeed show that investors like Republicans better than Democrats. Since 1888, the market fell an average of -0.5 percent on the day following a Democratic victory but rose by 0.7 percent on the day following a Republican victory. In the post WWII period, the day after election returns have been negative no matter what the outcome, however less negative when a Republican was victorious.

It’s also interesting to study returns in the first, second, third and fourth years of a presidential term. The returns in the third year of a presidential term (Democrat or Republican) are by far the best. This theory proves true over the past 113 years even with the devastating -43.3 percent drop that occurred in 1931, which was the third year of Hoover’s administration.

There are many theoretical explanations as to why these differences occur. One possibility is that Wall Street investors expect the Democrats to be bad for the market and sell their stocks before elections that the Democratic candidate is likely to win. Then, when the Democrats do not prove as bad as expected, stock prices rise again. Unfortunately the data does not support this theory. Another possible explanation is that economic policies under Democratic administrations may tend to be more volatile than those under Republicans, so investors demand higher returns to compensate them for the extra risk. Again, a clever idea, but it is also contradicted by the evidence.

The volatility of stock returns is slightly higher under Republicans than Democrats. Many think the causality might go the other way, with market returns driving presidential elections. Maybe voters feel wealthier when stock prices are high and then vote Republican: when stock prices are low, they vote Democrat.

As with anything involving research, if you torture the data long enough, it will confess to anything. As far as I’m concerned, the difference in returns through the political cycles is a puzzle and no matter what the outcome of this fall’s elections, the one thing to keep in mind is that market timing is seldom successful.

The stock market has good years and bad years, but over the long-term is inarguably a good investment no matter which side of the aisle controls congress or who sits in the oval office.

(Kerry Lee Watkins, CFA, is senior vice president and equity portfolio manager at Garner Asset Management Co. LLC, a registered investment advisor in Fayetteville.)

Real And Perceived

Here’s a historical look at annualized and real returns adjusted for inflation by party of the presidency, and below by presidential term:

• Average from 1888 to 2001

Presidency — Annualized Nominal Returns — Inflation — Annualized Real Returns

Democratic — 10.84% — 4.12% — 6.48%
Republican — 8.79% — 1.48% — 7.20%
Overall — 9.72% — 2.68% — 6.86%

•?Average from 1948 to 2001

Presidency — Annualized Nominal Returns — Inflation — Annualized Real Returns

Democratic — 15.23% — 3.64% — 11.25%
Republican — 10.31% — 3.96% — 6.11%
Overall — 12.55% — 3.81% — 8.41%

• Average from 1888 to 2001

Presidency — From One Day Before to One Day After the Election — First Year of Term — Second Year of Term — Third Year of Term — Fourth Year of Term

Democratic — -0.50% — 7.30% — 8.10% — 21.70% — 10.70%
Republican — 0.70% — 7.20% — 10.30% — 9.10% — 16.50%
Overall — 0.10% — 7.30% — 9.30% — 15.00% — 13.80%

•?Average from 1948 to 2001

Presidency — From One Day Before to One Day After the Election — First Year of Term — Second Year of Term — Third Year of Term — Fourth Year of Term

Democratic — -0.40% — 15.70% — 8.20% — 24.60% — 15.40%
Republican — -0.20% — 0.60% — 15.70% — 21.90% — 11.50%
Overall — -0.30% — 7.10% — 12.30% — 23.20% — 13.30%

Note: The above tables depict returns for the S&P 500 Total Return Index. The period 1888 to 2001 includes 29 presidential cycles with 20 different presidential administrations. The period 1948 to 2001 includes 14 presidential cycles with 10 different presidential administrations.

Source: Jeremy J. Seigel’s “Stocks for the Long Run” third edition