Historical data suggests that while stock returns vary under different administrations, the driver is economic risk aversion rather than partisan policy.

The Noise of Election Cycles

With every upcoming United States presidential election, a familiar wave of anxiety washes over the investing public. The rhetoric from across the political spectrum suggests that the very survival of the economy hinges on the ballot box. It seems intuitive that such a massive shift in leadership should dictate the direction of the stock market. However, when we step back from the heated commentary and examine nearly a century of data, a different picture emerges: one where the market is largely indifferent to the name on the door of the Oval Office.

If we look at the immediate short-term effects, the data is underwhelming for those seeking a clear signal. From 1926 through 2019, the 12-month periods following an election delivered an average return of 10.6%, compared to 11.9% for all other 12-month periods starting in November. While slightly lower, the difference is marginal. Out of 23 post-election years, only seven saw negative returns. The market, it seems, treats an election year as just another year in the long-term march of capital.

The Filter of Political Bias

One reason investors struggle to view elections objectively is the interference of personal bias. Research into political climate and investment decisions shows that individuals become significantly more optimistic about the economy when their preferred party is in power. They perceive the markets as less risky and the future as brighter simply because their 'team' won. Conversely, they view the opposition’s victory as a harbinger of financial doom.

The stock market, however, is an aggregator of all expectations, not just those of one faction. Prices are set at the equilibrium of millions of competing views. Because a win for either party is never universally viewed as a catastrophe or a godsend, the aggregate effect on asset prices is muted. The market effectively cancels out the collective biases of the electorate, which explains why we rarely see major stock market collapses stemming directly from election results.

Uncertainty and the Volatility Spike

While elections may not dictate the direction of the market, they certainly influence its temperament. Data suggests that stock market volatility tends to increase around tight elections, such as those in 2000, 2004, and 2016. This is linked to the 'Economic Policy Uncertainty Index.' When the outcome is a coin flip, the market cannot price in future tax, trade, or regulatory environments with any certainty.

This volatility is a reflection of the market processing information in real-time. As the probability of one candidate winning shifts, the market recalibrates. However, this turbulence is generally a short-term phenomenon. Once the uncertainty of the result is removed and the policy path becomes clearer, the market returns to its primary driver: the broader business cycle.

Solving the Presidential Puzzle

A more complex observation, often called the 'Presidential Puzzle,' is the historical fact that stock markets have delivered significantly higher returns under Democratic presidents. From 1927 through 2015, the excess return of the US stock market was roughly 11% higher per year under Democrats than Republicans. In fact, some researchers have noted that nearly all of the equity risk premium over the last century was earned during Democratic administrations. At first glance, this might suggest a causal link between Democratic policies and market prosperity.

However, a deeper look at the 'Political Cycles and Stock Returns' theory offers a more logical explanation. The difference likely stems from the timing of when certain parties are elected. Voters tend to elect Democrats during periods of high risk aversion—specifically during or immediately following economic crises, such as the Great Depression, the 1970s recessions, or the 2008 financial crisis. When risk aversion is high, the 'equity risk premium' (the compensation investors demand for taking on the risk of stocks) is also high.

The Reality of Risk Aversion

This model suggests that it is not Democratic policy that creates high returns, but rather that the same economic conditions that make voters want social insurance also lead to higher expected stock returns. When the economy is in shambles and unemployment is high, people vote for change. Because the market is at a low point during these crises, the subsequent recovery—which would likely happen regardless of the party in power—results in the outsized returns we see in the data.

Ultimately, the stock market is going to do what it is going to do based on underlying economic fundamentals. The 'Presidential Puzzle' is an empirical fact, but it is one explained by the starting point of the investment. For the long-term investor, the takeaway is clear: the equity risk premium is persistent for those who stay invested. Trying to time the market based on an election is a fool’s errand, as the most significant gains often arrive unexpectedly, regardless of who is giving the State of the Union address.