Theories abound, but there is only one certainty about the stock market and elections
Everyone is expecting a long, hard political fight between presumptive Republican presidential candidate Mitt Romney and Democratic incumbent Barack Obama. So much is at stake: U.S. foreign policy, healthcare reform, and the tax code could all undergo radical changes if Romney wins. If Obama comes out on top, the legacy of the policies he's championed in his first term would be established over the next four years.
But the winner of the election will have an affect far beyond policy. The outcome of the race will also impact the stock market. According to a number of different theories, a Republican or Democratic winner, and the simple occurrence of an election, has a direct impact on the stock market.
The outcome is up for debate. Some forecast a bull market if a Democrat wins, while other predict that a Democratic winner means stocks will decline. Other theories suggest that there is an annual pattern of cyclical stock performance based on the winner.
A savvy investor might see an opportunity to put these theories to the test, based upon who they believe will become president. If this investor bets on the right theory and the right winner, he or she could position himself or herself to make a lot of cash.
U.S. News reviewed a number of presidential election investment theories to determine which ones have merits and which are myths. We also consulted experts to determine if these theories were testable and reliable. And we determined that there is only one certainty about the stock market and elections.
Varied theories. Yale Hirsch, an investment advisor and the founder of the Stock Trader's Almanac, developed the most prominent election-year investment theory. In the Presidential Election Cycle Theory, Hirsch says stocks decline in the year immediately following the presidential election, then go up over the course of the next three years, no matter who wins the election.
Hirsch has historic data to back his point. In 1937, the first year Franklin Delano Roosevelt was president, the market was down more than 27 percent, then went up in the following years. The Truman and Eisenhower terms also followed the same pattern.
If an investor buys Hirsch's theory, he or she would place money into the relative safety of bonds in the year after an election, then move it to the stock market for the remaining three years of the term.
Unfortunately, modern presidencies have dented Hirsh's theory: The Dow Jones Industrial Average rose in the years following the elections of George H. W. Bush and Bill Clinton (more than 25 percent in the Bush presidency, and 20 and 36 percent, respectively, after Clinton's elections). But the two elections of George W. Bush were followed by down years. After Obama's election, the Dow went up.
Other theories suggest that the winning party determines the direction of the stock market. Conventional wisdom dictates that Republicans are friendlier to businesses, so stocks will rally after a Republicans wins the White House. Other theories suggest that the tone of a presidential campaign dictates the direction of the market. A positive campaign leaves investors with bullish sentiment, for example.
Answer not in the White House. According to James Kee, chief economist at South Texas Money Management, predicting stock performance based on who wins the White House is largely a guessing game.
"The general belief is that stocks tend to run up in election years when Republicans win and run down when Democrats win," he says. "People expect tax cuts when Republicans run, but politicians never really deliver on what they promise and the market sells off in the following year. With Democrats, there's a general feeling that there is going to be slow growth, but that's not always the case."
[See Investors' Herd Mentality.]
Kee argues that a better indicator of the direction of the market is who controls Congress. "When you have a Republican Congress, you have a very strong stock market in the following year and subsequent years ? mainly because Republicans are opposed to taxing dividends and capital gains," Kee says. "If Democrats win, you can bet there will be [talk of an] increase" in these taxes.
However, he cautions against using politics as an investment indicator. "This sort of analysis never pans out completely post-election. The markets never behave in a way that cab be obviously suggested," he says. "I don't think it's knowable. I don't think any of the models are good enough to tell you what the market's expecting."
More From US News & World Report