Tuesday, November 06, 2012

The Oval Office Effect

The fact that stock market returns are higher during Democrat presidential administrations versus Republican is well established and widely discussed.  Coolidge, a Democrat, presided over historic high stock market returns during The Roaring 20s.  Clinton’s administration in the 1990s comes in second place.  Stock returns during Obama’s current administration have been above average, but are still below those during the Eisenhower reign in the 1950s and Regan in the 1980s.

In October 2002 Pedro Santa-Clara and Rossen Valkanov published in the Journal of Finance an article entitled "The Presidential Puzzle: Political Cycles and the Stock Market" describing an extensive study of stock market returns by presidential administration.  They found that when a Republican president held office, the value-weighted return of the stock market delivered nearly a 2% premium over treasury bills. However, when a Democrat held office, the premium was nearly 11%.

That is a wide margin  -  a significant market anomaly.  The question is whether it is consistent enough to be exploitable by investors.

If the Oval Office Effect is just that, an exploitable market anomaly, investors should prepare to invest ‘long’ with Obama or ‘sell short’ with Romney on November 7th.  Ironic is it not, that after running as the pro-business and market-savvy candidate, as a Republican a Romney presidency is expected to have a chilling effect on stock market returns.  For that matter, it is not likely that Obama sees himself as a stock trader extraordinaire.

This topic comes up with every presidential election.  Yet I have yet to learn of any good explanation as to why the political party occupy the Oval Office correlates with stock market returns.  Business cycles do not appear to match party politics in the White House. 

There may be a connection to low interest rates during Democrat administrations and stock market returns.  The following graph illustrates closing prices for the S&P 500 Index (green line) in each year since 1955 and one year Treasury Bill rate (blue line).  The party of the president occupying the White House is depicted with red (Democrat) and blue (Republican) overlays.

First we can conclude with certainty that our finance professors were correct in characterizing an inverse relationship between stock market returns and interest rates.  We can also see that in each of the Democrat watches in the Oval Office the stock market marched upward with apparent determination, while we met with volatility and/or declines in the market while the ‘blue’ team held sway.  Of course the graph depicts only the last sixty years.
The Oval Office Effect, if there is one, does not hold all the time. Eisenhower in the 1950s was the only Republican to hold office during a period of market outperformance, while Roosevelt in the late 1930s and early 1940s was the only Democrat to preside over a significant underperformance in the stock market. What is more, it does not appear to kick in immediately after election day. Instead it builds over time. After Obama won the 2008 election, the market continued its downward slide until early February 2009. 
There could be some other element that the parties bring to the White House or leave behind to explain the Oval Office Effect  -  if there is one.  Any number of economic metrics could be juxtaposed against market returns.  Just for fun, I fould U.S. Census Bureau data on new business establishments.  The rate of net new business initiations (rate of new business entrances less rate of exits) could be a proxy for socio-political confidence that is inspired by expectations of the administration in office.  The next graph displays annual rates in net new business establishments (red line) in the years 1977 through 2010.
The graph suggests new business activity is not so closely linked to interest rates or wealth creation by the stock market as it might be to other factors.  It would take quite a bit more data, but I suspect that the two parties inspire political expectations that are ultimately played out in economic behaviors.
I am to going to vote and then plan tomorrow's trades while watching the 2012 election returns!
Neither the author of The Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.

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