- History shows the stock market performs best in the third year of a president’s first term.
- The market also shows a preference for incumbents and a government in which different parties control Congress.
- Given the pandemic-driven market conditions and uncertainty, it will be more difficult to estimate market performance leading up to the election in November.
In efforts to identify a discernable, profitable market pattern, much attention has been paid over the years to the so-called presidential cycle of average annual stock market returns.
- Year three of a president’s first term has historically produced the best market returns. This is presumably because the focus of policy shifts to actions to stimulate the economy, lifting the stock market and thereby enhancing reelection chances.
- In a president’s second term, year two has historically delivered the best returns.
Although such observations look at averages, historical circumstances vary widely, making sweeping return assumptions questionable.
The current election year is coming into focus. The president encountered little opposition from Republicans during the primary season. The Democratic field has narrowed to the presumptive nominee, former Vice President Joe Biden.
Although there are a number of important issues to decide in this year’s election, it is often said that people vote their pocketbooks. The current market environment is obviously quite challenging, and the economy has slowed sharply. How this will factor into the election remains to be seen, especially given the unique nature of the catalyst for the current downturn: COVID-19.
The stock market as an indicator of election outcomes
Beyond the relative strength of the economy, many will look to the stock market as a leading indicator for the election, particularly as we get into the summer months with the nominating conventions.
In post-war experience, stock market performance in election years tends to exhibit a seasonal pattern. There have been above-average returns in the spring and below-average returns in the summer, perhaps as anxiety rises ahead of the election. But in election years, whether the market is up or down for the year in late summer is viewed by some as a good barometer of sentiment toward the incumbent and a good leading indicator of how the election will turn out.
Others will watch how markets perform over the final two months before the election to determine where sentiment lies. In both cases, positive readings tend to bode well for the incumbent. Interestingly, market returns generally tend to be higher prior to the election when an incumbent is in the race. Markets also tend to be higher following the election when the incumbent wins.
Market volatility in election years
There also tends to be some seasonality to market volatility in election years. In post-war experiences, monthly volatility in election years is generally higher than average in the first half of the year, yet below average in the second half.
Volatility also tends to rise into the election, peaking on average in October. In years when there is an incumbent in the race, however, volatility is generally significantly lower than in years when there is not. This may be because there is less uncertainty surrounding the so-called “known quantity” of the incumbent.
Congressional makeup influences returns
The makeup of Congress exerts a large influence on average annual returns, well beyond which party controls the White House. Looking as far back as 1928, the best returns occur when there is a divided government (i.e., different parties control Congress), with a fractional advantage to when there is a Republican president and Democrats control both houses of Congress.
Heading into this year’s election, the Republican party holds a three-seat majority in the Senate, and there are 23 Republican senators up for reelection. The Democratic party has a 35-seat majority in the House, and all are up for reelection.
The only certainty this year is uncertainty
It is doubtful there is enough information in the average election year data to identify clearly investable market patterns. But as a discounting mechanism, it is interesting to note the market’s historical preference for incumbents. We see this in excess returns in the months just prior to and after the election.
This year, however, presents a unique set of circumstances. We have already slipped into the first bear market in 11 years, and we appear to be headed toward a recession. Normally, those circumstances might spell trouble for an incumbent. However, knowing how the electorate will respond this time around will have to wait until November.