Wall Street gets it wrong on presidential politics, experts say

But when it comes to the relationship between presidential politics and the behavior of the financial markets, a group of business researchers says that conventional wisdom might not be so wise.

The researchers reviewed more than 40 years of data (1965-2008) to examine the relationship between security returns and four variables:

• the political affiliation of the president;
• the presence or absence of political gridlock;
• the presidential term cycle effect; and
• Federal Reserve monetary policy.

While many academic papers have analyzed those factors separately, the authors of this study considered them simultaneously.

When all four of those factors were taken into account, the researchers concluded, many of the commonly held beliefs about how politics impact the market simply did not hold true.

Markets unmoved by a president's party affiliation

One of the most commonly repeated truisms called into question by the study is that the political affiliation of the president has an impact on the market. In reality, whether the president is a Republican or a Democrat is most often insignificant to the performance of the markets.

"While the party of the president garners much of the attention of the press, it appears that other factors have a much more prominent relationship with security returns," says Gerald Jensen, the Jones, Diedrich, Mennie professor of finance at the NIU College of Business. He has spent years researching the topics covered in the study.

The misconception about the president's party affiliation appears to have grown out of research that looked at isolated factors.

For instance, numerous studies have shown that stock returns (especially for small stocks) are substantially higher during Democratic presidencies relative to Republican administrations. Similarly, bond returns during Republican administrations are twice as high relative to returns generated during Democratic administrations.

However, Jensen and his colleagues found, when the other factors considered in this study are controlled, the difference in the performance of the markets across presidents from different parties is statistically insignificant.

Gridlock is not good

Many pundits and researchers maintain that political gridlock -- which occurs when different parties control the White House and the legislature -- is good for the market. Under such conditions, they reason, there is less chance of significant fiscal policy actions, which tend to disrupt financial markets.

In reality, the authors report, political harmony is better for equities.

That was especially true for smaller stock indexes where annualized returns were reportedly 22.38 percent higher during harmony as opposed to gridlock. Even when researchers adjusted for other factors, Jensen says, the benefits of political harmony remained clear.

Despite what the numbers say, the perception that gridlock is good has established itself. "It has been repeated so often I think that it has sort of been accepted as fact," Jensen says.

He speculates that people hang their argument on specific examples -- such as the Clinton presidency, when markets excelled despite political gridlock -- and fail to consider other evidence.

While it is clear that, during the period studied, political harmony coincided with strong equity performance, Jensen and his fellow researchers stop short of saying that there is a dependency between the two. "We have identified a relationship, but we aren't saying that one causes the other," he cautions.

Time will tell

While elections naturally bring up discussions of how politics influence the markets, Jensen and his colleagues found that political outcomes have little immediate impact. In fact, history has demonstrated that the most favorable return patterns are not manifested in the market for three years.

One theory is that the Federal Reserve loosens monetary policy in ways that reflect favorably upon incumbents in Congress and the White House to help encourage re-election. However, Jensen points out, even when the researchers adjusted for Fed policy changes, the economy seemed to consistently rally in the third year of a presidency.

It's all about the Fed

While much attention is focused on issues such as the president's political affiliation and gridlock, investors might be better served by paying less attention to those factors and more to how the election might affect Federal Reserve policy, Jensen says.

"A tightening of Fed monetary policy generally precedes poor equity market performance and increased inflationary pressures. Ultimately, that factor seems to carry the greatest weight, so that is what investors should pay attention to," he says.

"In the end, policies are more important than politics," he adds.

"While the chairman of the Federal Reserve is appointed by the president, I don't think people pay much attention to what party he comes from. Instead they watch what he is doing. Perhaps they should look at politicians the same way. It's not their party affiliations that are important, but the policies that they put forth."

The study, "What to Expect When You're Electing," was conducted by Jensen and co-authors Scott B. Beyer, associate professor at the University of Wisconsin Oshkosh College of Business; Luis Garcia-Feijoo, assistant professor at Florida Atlantic University College of Business; and Robert R. Johnson, professor of finance at Creighton University College of Business.

Key Findings

The key empirical findings reported in the study are consistent with the following:

• Equity investors, especially those that target small-cap stocks, would be wise to monitor Fed policy actions, while paying limited attention to the party of the president. Investors should be particularly wary of a shift to a restrictive Fed monetary policy.
• Contrary to the conventional view, equity investors should welcome political harmony; however, debt investors should prefer continued political gridlock.
• Fed policy shifts warrant consideration as potential signals of coming inflationary pressures. A shift to a restrictive policy stance should alert investors to higher future inflation and support a re-allocation to securities that offer more inflation protection (e.g., commodities and TIPS).
• Regardless of the political outcome in November, it appears that equity investors typically will have to wait until the third year of the next presidential term before reaping the benefits of the election season.