Trading The Presidential Election

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Includes: SH, SPXS, UVXY, VXX, XIV
by: Jonathan Kinlay

Summary

Now that the Democrat and Republican presidential nominees have been selected, what are the prospects for the market over the coming few months?

An analysis of market performance during the first 12 months of the term of newly elected presidents suggests that the "presidential effect" is generally positive for the market.

The market significantly underperforms during the first month of a new presidential term, but recovers to significantly outperform during the second month.

The article suggests various ways investors can look to take advantage of the phenomenon, using a mix of long and inverse ETFs, or option calendar spreads.

There is a great deal of market lore related to the US presidential elections. It is generally held that elections are good for the market, regardless of whether the incoming president is Democrat or Republican. To examine this thesis, I gathered data on presidential elections since 1950, considering only the first term of each newly elected president. My reason for considering first terms only was twofold: firstly, it might be expected that a new president is likely to exert a greater influence during his initial term in office, and secondly, the 2016 contest will likewise see the appointment of a new president (rather than the re-election of a current one).

Market Performance Post Presidential Elections

The table below shows the 11 presidential races considered, with sparklines summarizing the cumulative return in the S&P 500 Index in the 12-month period following the start of the presidential term of office. The majority are indeed upward sloping, as is the overall average.


Source: Author

A more detailed picture emerges from the following chart. It transpires that the generally positive "presidential effect" is due overwhelmingly to the stellar performance of the market during the first year of the Gerald Ford and Barack Obama presidencies. In both cases, presidential elections coincided with the market nadir following, respectively, the 1973 oil crisis and 2008 financial crisis, after which the economy staged a strong recovery.


Source: Author

Democrat vs. Republican Presidencies

There is a marked difference in the average market performance during the first year of a Democratic presidency vs. a Republican presidency. Doubtless, plausible explanations for this disparity are forthcoming from both political factions. On the Republican side, it could be argued that Democratic presidents have benefited from the benign policies of their (often) Republican predecessors while incoming Republican presidents have had to clean up the mess left to them by their Democratic predecessors. Democrats would no doubt argue that the market, taking its customary forward view, tends to react favorably to the prospect of a more enlightened, liberal approach to the presidency (i.e. more government spending).

Market Performance Around the Start of Presidential Terms

I shall leave such political speculations to those interested in pursuing them and instead focus on matters of a more apolitical nature. Specifically, we will look at the average market returns during the 12 months leading up to the start of a new presidential term compared to the average returns in the 12 months after the start of the term. The results are as follows:


Source: Author

The 12 months leading up to the start of the presidential term are labeled -12, -11, …, -1 while the following 12 months are labeled 1, 2, … , 12. The start of the term is designated as month zero while months that fall outside the 24-month period around the start of a presidential term are labeled as month 13.

The key finding stands out clearly from the chart, namely, that market returns during the start month of a new presidential term are distinctly negative, averaging -3.3%, while returns in the first month after the start of the term are distinctly positive, averaging 2.81%.

Assuming that market returns are approximately normally distributed, a standard t-test rejects the null hypothesis of no difference in the means of the month 0 and month 1 returns at the 2% confidence level. In other words, the "presidential effect" is both large and statistically significant.

How to Trade the Election

My sense is that an incoming president Trump is likely to be greeted by a market sell-off, based on jittery speculation about Donald's proclivity to start a trade war with China, or Mexico, or a ground war with Russia, Iran, or anyone else. However, the market will fairly quickly come around to the realization that electioneering rhetoric is unlikely to provide much guidance as to what a president Trump is likely to do in practice. I don't see the market doing as well in December as it would under Hillary Clinton, but neither do I expect it to be a disaster.

A Hillary Clinton presidency is likely to be seen, ex-ante, as the most benign for the market, especially given the level of (financial) support she has received from Wall Street. So one might expect a strong "Santa Claus" rally through the end of 2016. However, there's a glitch: Bernie proved much tougher to shake off than Clinton could ever have anticipated. In order to win over his supporters, she has had to move out of the center ground, towards the left. Who knows what further hostages to fortune a desperate Clinton is likely to have to offer the election gods in her bid to secure the White House?

In terms of the mechanics, I would definitely suggest a risk-off approach to the market in January, followed by a risk-on positioning for February 2017. Alternatively, one could consider buying put-protection for the month of January, or allocating short-term capital to inverse ETFs like the ProShares Short S&P 500 ETF (NYSEARCA:SH), or even a leveraged inverse ETF like the Direxion Daily S&P 500 Bear 3X Shares ETF (NYSEARCA:SPXS) at the end of December. Inverse positions should be lifted towards the end of January, and investors with an aggressive market outlook might add to their longs at that stage.

Another approach would be to buy long volatility ETNs such as the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX) or the ProShares Trust II - ProShares Ultra VIX Short-Term Futures ETF (NYSEARCA:UVXY) towards the end of December in anticipation of a rise in market volatility in January, which is often a volatile month anyway. Long volatility positions should be exited at the end of January and investors with an aggressive market posture might consider shorting those ETFs, or buying some short volatility ETNs in the month of February, such as the VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ:XIV).

For those looking to profit directly from this election cycle, I would suggest buying Jan '17/Feb '17 calendar put spreads in the CME E-mini S&P 500 index futures [CME:ES] towards the end of December, which will also position you long volatility. A less risky strategy for those who prefer income-generating ideas would be to short the equivalent call spreads.

Disclosure: I am/we are short UVXY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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