InvestmentsJan 18 2016

Will the US election cycle impact stocks?

twitter-iconfacebook-iconlinkedin-iconmail-iconprint-icon
Search supported by

There is an election cycle theory that suggests in the third and fourth year of a president’s term the S&P 500 index performs better, and struggles in the first two years of a presidency. But does this have any basis in fact?

Sam Stovall, US equity strategist at S&P Capital IQ, says: “I believe there is correlation with causation, meaning it’s not like the ‘Superbowl theory’ where you have correlation without causation.

“The reason why I think the third year of a president’s term is traditionally the best year is because the party in power wants to stay in power by introducing stimulative legislation in the third year that will typically bear fruit in the fourth year and make voters feel better about the party in power, and re-elect them.”

As to how this affects investors, he points out “Wall Streeters” are anticipators, and so are not going to wait to see if the stimulus bears fruit – they will assume it does and will buy into the market in the third year. However, the cycle did not work in 2011 and 2015 – the third years of the cycle for President Obama’s first and second term – because the US was reducing stimulus rather than injecting it.

But while data can back up the theory in other election cycles, it depends on what time period you look at and which election cycles you choose.

Frances Hudson, global thematic strategist at Standard Life Investments, explains: “To an extent this falls into the lies, dammed lies and statistics camp, in that I have seen research that goes back to 1900 and finds that the eighth year of a presidential term produces average falls of 15 per cent compared with average rises of around 6.5 per cent in all election years.”

Jake Robbins, senior investment manager at Premier Asset Management, agrees the theory “has a very hit-and-miss history, and shouldn’t really be relied on as a reliable guide to returns”.

Instead he suggests the pace and size of interest rate hikes in the US, the extent of the continuing slowdown in the Chinese economy, and whether or not the ECB and Bank of Japan “attempt to resuscitate their ailing economies with further bouts of QE over the year” will be more important.

Mr Stovall agrees there will be a lot of nervousness surrounding earnings growth in the first half.

He adds: “I believe the second term’s fourth year will be weaker than the average, but it might end up having a positive August through October because investors will begin to feel good that we’ll have a new president and possibly even a new party in power.”

Ms Hudson believes the political make-up of the Senate and House of Representatives will determine policy direction “as much as, if not more than, the stripe of the president”.

“For companies, the policies that matter are probably those that concern tax and regulations, but markets, as we know, trade on sentiment as much if not more than sensible analysis, so positive feelings towards the likely winner will count for a lot,” she says.

The choice of candidates could also affect market performance, with Mr Robbins noting markets typically cheer at the prospect of a Republican victory, as they are regarded as more business-friendly.

“However, in this instance, if the prospective Republican president is [Donald] Trump then markets may react better to Hillary Clinton winning the race, due to his somewhat erratic policies and behaviour.”

Mr Stovall notes the way biotech stocks reacted negatively to Hillary Clinton’s comments about controlling prices show the market already believes she will be the Democratic nominee, and shows why investors also need to look at industries affected by party policy.

In 2012 president Obama said he would raise taxes on dividends and Mitt Romney said he would undo Obamacare. And in the run-up to the election, higher dividend-paying stocks declined and healthcare moved higher, suggesting the market felt Obama would win.

“Once the candidates are selected and we hear what their platforms are, we can identify with particular industries to say if this industry goes up it’s probably because it anticipates Clinton or Trump, or whoever the two candidates are, will be elected,” says Mr Stovall.

Nyree Stewart is features editor at Investment Adviser

Election theory: Does it work?

Developed by Yale Hirsch, the theory suggests that stockmarkets perform worse in the first two years of a president’s term after an election, and perform best in the third and fourth years before the cycle begins again. The third year of a term, the one leading up to the next election, is presumed to perform the best.

But while historical data and theories can produce interesting patterns, are they useful for today’s investor?

Sam Stovall, US equity strategist at S&P Capital IQ, says: “What I try to do is extract emotions by looking at historical precedent, not that I’m necessarily going to react to it and sell out. So use it more as an acknowledgement of what might happen so you’re not taken by surprise.”

Edward Smith, asset allocation strategist at Rathbones, comments: “As a macro-oriented strategist, I am always deeply wary of technical analysis that makes no attempt to cross-reference with the business cycle. US election cycle theory – which holds that equity markets post poor returns in the first year after a presidential election – is a case in point. The theory, which first gained popular approval in the early 1970s, worked well between the 1932 and 1980 elections because the first year coincided with a recession in an uncanny number of instances.

“Since 1984 the theory has been bunkum. And that’s because in every instance bar one, the first year of a presidential term landed in the middle of an up-trending business cycle. Indeed since then, the first year of a presidential term has been the best year for equities relative to the other three years of the term in five out of eight instances.”

Neil Williams, group chief economist, Hermes Investment Management, adds: “With the US recession seven years behind us and the Federal Reserve in the policy driving-seat, the build-up to November’s election should not be a game-changer for financial markets. It will again be the Fed driving macro policy in 2016 and even 2017, leaving – in macro terms – the presidential race as largely a sideshow, the outcome to which is unlikely to knock either the Fed or, as a result, the economy off course.”