Monday, February 22, 2016

Political Uncertainty Can Hurt Stock Prices


Politics is in the air. With the latest results from the South Carolina Republican primary and the Democratic Nevada caucus the field is starting to narrow. On the Democratic side, after fending off and surviving the growing momentum of the Vermont Socialist Senator Bernie Sanders, we anticipate Clinton will build her own momentum going into South Carolina and should start to pull away from this point to be the likely Democratic candidate barring criminal findings due to her mishandling of emails as Secretary of State or conflicts of duty with her foundation while serving.



One the Republican side, the outlook isn’t as clear. In past races it usually came down to the mainstream candidate and the close runner-up usually the evangelical conservative. Think back to 2008 it was John McCain as the mainstream pick with Mike Huckabee hanging on until the end. In 2012 Mitt Romney was the mainstream guy and Rick Santorum coming in a close second. This year we would liken Marco Rubio as the mainstream pick with Ted Cruz hanging on until the bitter end but ultimately conceding defeat to the “establishment” candidate. But then you toss in Donald Trump and the picture gets cloudy. With Trump leading in most of the polls this adds a layer of uncertainty that is sure to affect the market in some way as market participants do not like uncertainty.




It’s a rather sticky situation for Republicans. As the chart above shows, Trump leads the other Republican candidates by a fairly wide margin nationally but as the following charts show, when given the choice of Trump, Cruz or Rubio, Trump is the only candidate that doesn’t match up well against Clinton nationally.    






We will see how this eventually plays out but one would think this could be unsettling for the stock market. I re-read Markets Never Forget – But People Do by Ken Fisher this weekend. Towards the latter part of the book Mr. Fisher shares his insight on historical trends during the entire political process.
Market Turbulence
Mr. Fisher points out, “Again, forecasting markets over the next 12 to 24 months is, in large part, about shaping a set of likely outcomes, understanding what most people expect, and then understanding how divorced expectations are from that likely future reality, for good or bad.
This is why markets can soar on lackluster economic growth or lower corporate profits. This is why markets can have a lousy year even if economic growth is strong. It’s not about what happened or what you hope happens. It’s about what most people were expecting and how they react when a better – or worse – than – expected reality plays out.”
The logic seems to make sense and he goes on to apply the theory to risk aversion and Presidential cycles. He writes, “Table 7.1 {I have recreated it below} divides returns into first, second, third and fourth years of each president’s term. For now ignore individual years; just look at the averages. First and second years average 8.1% and 9.0%, while third and fourth average 19.4% and 10.9%.
Interesting enough pattern. Now look at individual years. The back half of presidential terms – years three and four – are nearly uniformly positive. Year three doesn’t have a single negative since 1939, which was barely negative. Year four has just four down years. And returns are not always but frequently are double-digit positives.”




Bear in mind this book was written several years ago and it turns out President Obama’s third year of his second term, last year was negative. That said the historical relevance holds. Mr. Fisher goes on to explain this phenomenon with a fundamental backdrop.
“And here, there’s an excellent fundamental explanation – tied to when legislative risk aversion is increasing or decreasing. Legislation – no matter how it’s couched or how many thousands of pages it’s on – typically results in a redistribution of money, property rights or regulatory changes…Vast amounts of academic research proves humans hate losses more than twice as much as they like gains; i.e., a 25% gain feels as good as a 10% loss feels bad. That’s true for Americans. For Europeans, it’s even higher. So when the risk of legislation increases – as it typically does in the first two years of a president’s term – those who lose out hate losing much more than those who benefit from it like benefitting. Because we do it openly and publically, it feels like a mugging, and anyone not directly involved fears they’ll get mugged next – leading to heightened risk aversion overall and more variable returns with worse averages – just as you see in Table 7.1. But when legislation risk aversion decreases – as it typically does in years three and four – stock returns historically have been more uniformly positive.”    
The question arises as to why legislation risk aversion is more prevalent in the first two years of a presidential cycle. Mr. Fisher explains, “They know in the history of modern presidents, the president almost always loses some relative power to the opposition party in mid-term elections…Therefore, the president knows that whatever he would pass that is most monumental – the crown jewel of his administration – must be passed in the first two years of his term (I say his because they’ve all been male so far), because he’ll likely face a bigger uphill battle in the back half when he loses relative power.”
Indeed it has been said that the stock market favors “gridlock” and the results in table 7.1 establish that notion. Let’s speak a bit about a sitting presidents fourth year going into a new first year, as we are this year. Mr. Fisher writes, “Republican politicians see themselves as more pro-business. When they campaign, they say business-friendly things and promise business-friendly reforms – and markets typically like that. Democrats are seen as less business friendly, more interested in non-market oriented social causes. Markets like that less. So election years (year four) when we elect a Republican, stocks rise 15.6% on average, but only 6.7% when we elect a Democrat. (See Table 7.2) Simple fact – other things being equal – if you knew in advance we would elect a Republican president, that might be extra motivation to be more bullish election year than if you knew in advance we would elect a Democrat...When we elect a Republican, the market does great in the election year but not so well in the inaugural year. And just the reverse – when we elect a Democrat, the market does less well in the election year but pretty darned well in the inaugural year.”




He goes on to explain why this anomaly exists. “The moment a Republican gets elected, he’s no longer a candidate, but president, and he starts thinking about re-election. He needs independent voters and marginal Democrats to get re-elected – he knows his Republican base has nowhere to go. A Republican president can’t ride on a wave of deregulation, lower taxes or whatever it was he promised…Markets discover he’s not as pro-business as they hoped. He isn’t their pro-business champion. No, he is, rather, just a politician, so a Republican’s inauguration year is more variable, averaging just 0.8%.”
“But the Democrat! He’s just a politician too. He came in vowing to go after Wall Street fat cats and fight for the little guy – which scared the dickens out of markets in the election year – contributing to lower election year market averages. But he wants to get re-elected too, and doesn’t want to annoy Wall Street fat cats (who make a lot of campaign contributions). He, too, must move to the middle if he is to have a hair of a chance at re-election. It’s the middle that makes the decisions. Markets then are pleasantly surprises the Democrat isn’t quite so business-unfriendly as they feared, and the first year of a Democrat’s term, they average 14.9%”
The figures become even more fascinating in election cycles in which the incumbent president isn’t running. This is what we face this year.
“Markets typically do well when we elect a Republican in the election year and fear a Democrat. But that effect is magnified in first-term elections and diminished in second term elections. When we newly elect a Republican, the markets have especially high hopes – stocks have averaged 18.8% in those years (see Table 7.3). And a newly elected Democrat is even spookier – stocks average -2.7%.”




“Markets are really relieved the newly elected Democrat isn’t an out – and – out socialist – rising an average 22.1% his inaugural year. Whereas the not – so – business – friendly – as – hyped newly elected Republican sees stocks fall an average -0.6% his inaugural year.”




A Unique Election Year
Just a few short months ago it appeared we were setting up the field for a showdown between two “establishment” candidates. Like setting up a chess board most were expecting a Clinton vs. Bush race to the white house. If that were the case then everything we’ve discussed above would seem pretty cut and dry. We know just from looking at the Clinton campaign logo (the “H” with a big red arrow pointing right) that she would gravitate to the center once nominated and Bush is…well…a Bush.





Fast forward to today and we find Clinton is barely able to squeeze out victories against Sanders, the Vermont socialist that was little more than a political sideshow at the start of the race and Bush dropping out unable to gain any traction with his campaign. That chess board that we set up turned into a game of chutes and ladders.
Perhaps the voting public is on to the political game that has taken place for so long. Given the most outlandish proposals, such as building a great wall and having Mexico pay for it or giving everyone free everything financed by those of us that work on Wall Street, their political wherewithal is astonishing. The appeal for voters is the sincerity behind these candidates’ proposals regardless of its feasibility. People just appear to be sick of typical politicians.   
This is bad news for the stock market. There are several layers of uncertainty in this race and in my opinion unprecedented voter angst at least in my generation (born 1970’s).
There are several reasons why we believe the stock market has yet to hit the lows for the year – slowing global economic growth, weakening corporate earnings and a technically broken stock chart that is signifying a new downtrend. Under normal circumstances I would say that in the end this would hurt Clinton’s chances at the presidency as she is running on a third Obama term when the voters are clearly calling for something different. Given her baggage from the State Department and a slowing economy and weak stock market this would appear to be a layup for Republicans if it wasn’t for the mass chaos that exudes from the GOP almost on a daily basis.
Again this is bad for the market.
What the Market is Telling Us
According to an article entitled What You Should Know About the Markets in 2016 found on the AARP website, “The stock market has gained an average 5.8 percent in the fourth year of a president's term since 1833, says Jeff Hirsch, editor of the Stock Trader's Almanac. But the picture is not as clear in a president's eighth year. The Dow Jones industrial average has lost an average 13.9 percent in a full two-term president's final year since 1900 (there have been only six), Hirsch says. By the end of a second term, Wall Street senses change in the air. Wall Street hates change.”
He goes on to predict the following, “In 2016, the stock market might be a better indicator of who is going to win the election than the election will be an indicator of how the stock market will fare, says Sam Stovall, the U.S. equity strategist for Standard & Poor's Capital IQ. "If the market is up between July 31 and Oct. 31, then 8 times out of 10, the incumbent party is reelected," Stovall says. "If it's down, the incumbent party is replaced."”
We came across another article in The New America entitled Stock Market Is Predicting a Republican President. In the article they write, “Mark Hulbert’s study of correlations between the stock market and presidential elections and Jeff Hirsch’s Stock Trader’s Almanac are making a powerful case that, come November, it will be a Republican occupying the White House for the next four years… According to Hulbert, the correlation between the stock market and presidential elections is remarkable: “A strong stock market is correlated with the incumbent party winning. A declining stock market is associated with a change in parties at 1600 Pennsylvania Avenue.” To cover himself, Hulbert notes that “correlation is not causation” and that the conclusion is “suggestive [rather] than conclusive.” But with stocks down hard so far this year — the Dow Jones Industrial average is down eight percent for the year, while the Standard and Poor’s 500 Index is down nine percent and the NASDAQ is off 14 percent — the market is going to have to reverse itself mightily to keep a Democrat in the White House.”
“Since 1920, according to Hirsch, the eighth years of presidents serving two terms have experienced the worst stock market performance, with the Dow, on average, losing 14 percent and the S&P 500 showing average losses of 11 percent. The market showed losses in the final year of an eight-year term five times out of the last six two-term administrations.
It gets worse for the Democrats. Hirsch’s January Barometer shows that as the first five days of trading goes, so goes the market for the year. And if January itself is down, then it bodes ill for the market for the rest of the year as well.
One need not be reminded that the first five trading days of 2016 were the worst opening week in stock market history.”
There also appears to be a level of excitement and urgency from the Republican side that isn’t quite there on the Democratic side. “The groundswell was noted in both the Iowa and New Hampshire primaries by Stephen Dinan in the Washington Times: Republicans set a new turnout record Tuesday in New Hampshire’s primary, attracting more than a quarter of a million voters to the polls and offering evidence that most of the energy in the 2016 presidential race continues to be on the GOP side….The New Hampshire results follow last week’s Iowa caucus turnout, where Republicans easily outdistanced Democrats by more than 50 percent.”
Beyond The Presidential Cycle
There has been some interesting work done on presidential cycles and the stock market. One such paper that I read recently is Stock Market, Economic Performance, And Presidential Elections. This paper was written by Wen-Wen Chen from State University of New York at Old Westbury, Roger W. Mayer from Walden University and Zigan Wang from Columbia University.
They found, “GDP growth rates under Democratic administration in the second, third, and the fourth years are greater than growth under a Republican administration. The difference in the second year has enlarged since 1953, while the differences in the third and fourth years have shrunk during the second half of the 20th century. The average cumulative GDP growth for four years under Democratic administration is 18.51 percent since 1900 and 15.33 percent since 1953, while under Republican presidents the numbers are 10.71 percent and 11.21 percent, respectively (see Figure 1).”





They go on to conclude, “The authors’ study adds to the literature on examining the relationship between a presidential administration and the economy. The researchers demonstrated that GDP growth is associated with the prediction of the Wall Street, as defined by the change in stock price immediately after the election. This relationship has strengthened over time. The researchers were not able to identify the same relationship between stock market change immediately after an election and unemployment. The divergent results may be explained by the political economy framework and the strong relationship between business and the presidential administration. Given that the focus of business is on growth and not full employment, these results suggest that when Wall Street casts its prediction after an election, the prediction focuses on growth and excludes unemployment variables. Additional research is needed to determine how GDP, unemployment, and presidential policies interrelate.”




“Table 4 shows six regressions of which (1), (2), and (5) show the results of a sub-sample of the most recent ten administrations from Richard Nixon/Gerald Ford in 1972. Models (1) and (2) show that for the most recent ten administrations, the 1-day DJI percentage change following the Election Day is a significant predictor of the cumulative GDP growth of the following four years. However, Models (3) and (4) show that the prediction has no significant accuracy when all 28 administrations since 1900 are included. Models (5) and (6) show that the 1-day DJI percentage change following the Election Day and the average unemployment rate of the following four years has no correlation in both the sub-sample and the full sample.”





Thus in more recent history, the action of the stock market almost immediately after a presidential election has predictive ability in telling us about economic growth over the next several years. This should be interesting to see if the market will gain traction and resume its bull trend prior to the election, when the election dynamics itself may be increasing uncertainties that ultimately hurt the chances of a new uptrend.
In the end we do care about the political spectrum as it relates to finance and the economy. We have written in the past about political issues that we care deeply about.
November 26, 2015 - Revitalizing the American Dream
September 13, 2015 - Shackling The Invisible Hand
November 19, 2014 - Power Dinner
November 4, 2014 - Irresponsibility in Government
That said, it is just one aspect that we attempt to analyze when constructing and trading our portfolio and not necessarily a large input.
Bottom Line: The current political picture is adding a layer of uncertainty around the market and that could impact prices negatively. We believe that the deck is stacked against Clinton at this point for several reasons (1) lingering ethics questions from her time at State, (2) disenfranchised Sanders supporters if she gets the nomination (I say if due to the ongoing FBI inquiries – not because I think Sanders will get the nomination), (3) low “likeability” and “trustworthiness” rating, (4) weaker global economic and US growth and a stumbling stock market, (5) running on an Obama third term platform when much of the voting public are looking for change.  What should be a shoe in for Republicans is blocked by chaotic campaigns, too many candidates and the Trump Wild card.
 
Joseph S. Kalinowski, CFA
Email: joe@squaredconcept.com
Twitter: @jskalinowski
Facebook: https://www.facebook.com/JoeKalinowskiCFA/
Blog: http://squaredconcept.blogspot.com/

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