Political Party Power and Its Affect on U.S. Market Return

by: Bryan Keller

Few things cloud a person’s objectivity faster than the insertion of politics into a conversation.

 

Simply stated, when political issues and platforms can be boiled down to bumper sticker slogans and backpack patches to bolster support, the absence of perspective and detail greatly detract from one’s ability to objectively analyze the topic at hand.

This phenomenon typically hits a crescendo during a period every four years, lasting for a few months (or, in our current cycle, almost a year now) leading up to November 4th, when we look to elect a new President.

And, like clockwork, many within the investment management business see the opportunity to satisfy their client’s cravings with a double dosage of market and political analysis – specifically; “What is the market going to do?” and “How will this election affect the market’s performance?”

As for Kobren Insight Management? Well, we’re guilty as well.

But we, as done throughout our entire investment and research process, would like to take a different look into this collision of politics and investments, with the ultimate goal of providing a more complete perspective and analytical objectivity, without attempting to backfill our findings into some preconceived political platform.

So let’s review some of these widely held beliefs regarding the stock market, and politics:

  • Republicans are better for the stock market: as they espouse lower taxes, smaller government, free trade, stronger defense, and are more supportive of small business owners

  • Democrats are worse for the stock market: as they promote larger entitlement programs (Welfare, Social Security), higher taxes, protectionism, larger government and government spending, and hold anti-corporation tendencies

Aside from being overly simplistic generalizations, those above clichés fail to capture some of the key inputs of an investor’s true experience. I challenge anyone to cite a widely quoted adage related to the association between political party rule and its effect on fixed income returns and inflation – key components of a balanced, diversified portfolio. 

This spotlight will take an objective, unbiased, and data-driven approach to analyze what, if any, influence the two major political parties have on investors’ diversified portfolio returns – including the impact of inflation – in an attempt to provide clarification to an often murky and prejudiced subject.

 

“The more you read and observe about this Politics thing, you got to admit that each party is worse than the other. The one that's out always looks the best.” ~ Will Rogers

Findings and Analysis

As explained in the “Background and Process of Study” section of this report, our ultimate goal was to find which party provided  the highest inflation-adjusted equity, fixed income, and balanced portfolio returns. Additionally, we then sub-analyzed the data using the following guidelines, in an attempt to account for other legitimate scenarios:

  • Median Returns

  • Average Returns

  • Lagged Returns (6 months)

  • Party Specific Transition Returns (defined in Background)

  • Non-Party Specific Transition Returns (defined in Background)

Each of the above data points will be performed separately for the Presidency, Senate, and House of Representatives.

And the results?

Equity Performance and Political Party Control

click to enlarge images

Contrary to conventional wisdom, the stock market has historically performed better under Democratic Presidents, though Republicans have been in control of the House and Senate during the better performing periods for equities. It should also be worthwhile to note the number of data points for each series. Since 1928, Republican’s have been in control of the presidency for 485 of the 962 (50.4%) months, while they’ve only been in control of the Senate and House of Representatives for 300 (31.2%) and 252 (26.2%) months, respectively.

Looking at the data from a different vantage point, when the data is lagged by six months, in an attempt to associate market returns to the administrations that had enacted them in the first place, even after they’ve left office, the overriding story remains the same. The decision to lag the data is based on the premise that governmental activity (tax increase/decrease, rebate checks, interest rate cuts) takes a while to trickle down through the economy, so the effects of the decisions made by a president during month N, wouldn’t have fully made its way through the economy until month N+6. Using the lagged method, an administration would begin being associated with market performance six months into their presidency, and will stop receiving the final market return association six months after their term had actually ended.

The story gets even more interesting when the Transition concept is introduced. The “Party Transition” numbers attempt to isolate the effects of a certain party coming into power, taking control from the other. To calculate the Party Transition, we took the average monthly returns of the three months prior to, and after, the transition date, and attributed those returns to the incoming party. To use this upcoming election as an example, if a Democrat wins the presidency in November, he or she will be credited with the S&P’s returns from October through March of 2009. We captured these transition numbers going back to 1928 to arrive at the numbers presented in the above graphic.

As the above graphic illustrated, the market has historically had huge gains when Democrats take over the Presidency from a Republican incumbent, with outperformance at about 47% above the transitional periods when Republicans take over.


Before you decide to take out a home equity loan to lever up on equities in anticipation of a Democratic win this fall, let’s put a few things into perspective:

  1.  

    The best three transition months for the Democrats were April, May and June of 1933 – the three months after Franklin D. Roosevelt was elected, and America finally began scratching its way out of the depression. Stock market returns in those situations can be powerful, and the scenario in which they occurred is unique to that time period

  2. Looking at the median transition returns for Democrats, instead of the average, calculates to 17.75% -- still robust, but much more tame

  3. Removing the three months referenced in point #1, equity returns average just 4.91% during Democrat Party Transitional periods

  4. Similarly, but with the reverse consequence, the Republican’s three worst monthly periods occur in November, March and April in the 2000-2001 transition during the pop of the Internet Bubble, and though removing them would close the gap with the Democrats, the Dems still maintain a healthy lead.

  5. And, of course, the obligatory compliance by-line: past performance is not necessarily an indication of future results

The “Transition” returns apply the same concept as the Party Transition returns, but does not isolate or attribute a specific political party to credit the returns to. Instead, we simply ask the question “What are the average returns in the three months leading up to, and following, a transition in the Presidency?” The numbers that are associated with a political party in the above graphic show the historic equity returns when the transitional periods are removed. Remember, in both the Party Transition and Transition calculation, when the same party enters into office that was previously there, no transition is made.

In total, there were 48 instances of months that fell within the “Transition” definition. It just so happened that both the Republicans and Democrats had an equal amount – 24 each.

“We are imperfect.  We cannot expect perfect government.”~ William Howard Taft

Fixed Income Performance and Political Party Control

Though the returns for the Fixed Income markets generated different outcomes, interesting underlying stories remain. As stated above, Republicans make a clean sweep for the best performance of the fixed income markets under their watch, though the GOP still fairs poorly in the Party Transitional periods, underperforming incoming Democrats by 700-800 bps.

A factor that has a greater impact on real fixed income returns then it does equities, is the impact of inflation. Across the board, inflation (as measured by Consumer Price Index) has been higher under Democrats then it has been under Republicans (with sole exception of the Presidency). Interestingly though, inflation does seems to tame during the periods when a Democrat is coming into office, and spike when Republicans are headed into office, with the difference between the two as large as 8.23% during party transitions for the House of Representatives (see chart below).


Again, the transitional periods continue to produce outsized gains in the fixed income markets relative to returns measured using more conventional methods. During the Transition period, the fixed income market has averaged returns well in excess of median fixed income returns, a shared trait with the equity markets.

“Government is too big and too important to be left to the politicians.” ~ Chester Bowles

Balanced Portfolio Performance and Political Party Control

Tying together the historical returns of equities and fixed income, we can see that Democrats still come out ahead with the Presidency for a balanced portfolio. And again, the level of outperformance for Democrats during Party Transition periods is staggering! It is though, interesting to note the difference in performance when the Presidency data is lagged, as Republicans actually come out ahead – possibly implying that the policies implemented by Republicans still have positive effects on the marketplace even after their tenure in office has ended. This rationale would help to partially explain the Party Transition numbers for Democrats as well, as the final three months of that calculation would overlap with the Lagged periods.

On the Senate and House side, the numbers are much closer, though Republicans seem to do better across the board. As mentioned earlier, part of the reason for Democratic underperformance is the higher level of inflation that tends to occur under their terms in office. This “silent killer” eats away at the “real” returns of equities and fixed income.

 

“The most important political office is that of the private citizen.”  ~ Louis Brandeis

 

Conclusion

So after looking at the historical returns of equities and fixed income, and the impact our political system has had on these returns, why even bother diversifying away from the high level of returns that equities have historically provided, even on an inflation adjusted basis? Furthermore, the seemingly high potential for a Democratic win in November, and the equity returns that would typically follow, surely points to allocating a large portion of assets to the stock market, right?! Not so fast!

 

As the April edition of KIM’s Letter from the Portfolio Managers stated, equity returns over the past ten years (through April 30th) have under performed most fixed income indices, and even cash! So even though equities have historically outperformed most other asset classes, it doesn’t mean that it won’t have periods of underperformance.

Additionally, though the analysis done in this paper may have come to the conclusion that historically incoming Democratic Presidents have been good for the stock market, in no way can that be extrapolated to mean that we think they will continue to be in the future. There are many, many other underlying currents out there – both positive and negative – that will have greater impacts on the stock market then will the election of a figure head (Republican or Democrat) to an office that often times is more ceremonial than substantive to the daily grind of the economy.

For example, had an individual used this strategy during the 1976 Carter/Ford Presidential Election, investing in equities starting October 1st, 1976, through March 31st, 1977, to take advantage of the perceived Democratic Transition Premium, that opportunist would have lost 4.5%. An argument can be made that the environment during that period – both politically and economically – is more comparable to today then past periods of potential party transitions.

Ultimately, this entire subject is of the cum hoc ergo propter hoc variety, where one mistakes correlation for causation. Because of the perceived historical correlations between market returns and political majorities, the leap to causation – though it may be an easy one to make – is not only just a well established fallacy, but a poorly conceived investment strategy.

For these reasons, and ones which we have consistently advocated to our clients for many years, it is important to maintain a balanced and diversified portfolio. Yes, political activity in Washington does play a small role in our overall investment process. But ultimately it is asset allocation, fund selection and relative sector exposure that is the difference between a lengthy period of underperformance, and the ability to reach your long-term financial goals.

Background and Process of Study

The process of this study is structured as follows:

  •  We gathered monthly total return data going back to 1928 for the following items:
    • Equities (S&P 500 total return)
    • Fixed Income (Ibbotson Intermediate Bond Index*/Lehman Brothers Intermediate Bond Index**)
    •    Consumer Price Inflation (Index)
      • Monthly data points from 1/31/1928 through 12/31/1975
      • Monthly data points starting 1/31/1976
  • Additionally, we collected the following political information:
    • History of political party majority in the House and Senate dating back to 1855
    • Political affiliation of all US Presidents back to 1853
  • Further analyzing the returns data, we broke-out the results into a few different objectives:
    • Median Returns – total, and based on political party
      • Using median, instead of averages tends to smooth out some of the outlying data points that can skew the overall trend
    • Average Returns – total, and based on political party
      • Averages do incorporate the outliers into the calculation, but can help confirm and put into perspective other points of data
    • Lagged Returns – based on political party
      • There’s a common belief that most governmental action (tax rate increase/decrease, fiscal stimulus, monetary policy changes, elections) do not have an immediate impact, but instead take a while to “trickle down” through the system. We have chosen to lag the month in which the political party in power is associated with that month’s return. For example, the political party in power of the Presidency on
    • Returns during party specified transitions – based on political party
      • We looked to see what, if any, impact the incoming party would have on the market, before they were elected to office. To do so, we isolated the three months before, and three months after a “transition month” and calculated the average returns of those months by which party was coming into power
    • Returns during non-party specified transitions – based on political party
      • Similar to above, with the exception that we did not isolate the returns based on a specific party coming into power. Our calculations were based simply on the fact that there was a transition, period.
  • The final data was then analyzed in the following targeted output, and separately done so for each the Presidency, Senate, and House of Representatives:
    • Inflation-adjusted equity returns based on political party in power
    • Inflation-adjusted Fixed Income returns based on political party in power
    • Inflation-adjusted returns of a balanced portfolio (60% equities/40% fixed income)