How wise is the conventional wisdom of market politics?

It’s an axiom of market politics: Historically, investors win during presidential election years.

Conventional wisdom holds that the market runs a bearish-to-bullish, four-year presidential election cycle from the first year of a president’s term. The stock market typically struggles after inauguration, gains momentum during pre-election years and produces positive returns in presidential election years. But the reality is that three of the last four election cycles have run counter to that pattern, as the chart below shows.

Bearish to Bullish or Bullish to Bearish?
Elected President	Four-Year Cycle Began (Calendar Years)	Post-Election- Year Returns1(%)	Mid-Term- Year Returns1(%)	Pre-Election- Year Returns1(%)	Election-Year Returns1(%)
Bill Clinton (D) (second term)	1997	33.36 (1997)	28.58 (1998)	21.04 (1999)	-9.11 (2000)
G.W. Bush (R)	2001	-11.88 (2001)	-22.10 (2002)	28.70 (2003)	10.87 (2004)
G.W. Bush	2005	4.91 (2005)	15.80 (2006)	5.49 (2007)	-36.99 (2008)
Barrack Obama (D)	2009	26.47 (2009)	15.08 (2010)	2.09 (2011)	13.502 1/1/12 - 8/31/12

1 Annualized total returns

2 Cumulative total return

Source: Lipper. Past performance cannot guarantee comparable future results. The stock market is represented by the S&P 500® Index, an unmanaged index considered representative of the U.S. stock market. An investment cannot be made directly in an index. Returns reflect the reinvestment of dividends.

Here’s another bit of conventional wisdom: The market rallies after the election of a Republican because that party is perceived to be friendlier to business. Conversely, electing a Democrat sends stock prices down. Reality: Over the last four election cycles, the rallies occurred when Democrats won.

And then there’s the chicken-or-the-egg debate. Does the market determine the election or vice versa? Or both?

For example, conventional wisdom dictates that a market rally preceding the upcoming election would favor incumbent President Obama. But in this presidential election cycle, a market rally may not trump sagging home prices and a feeble job market at home and a barrage of bad economic news from abroad in voters’ minds.

Could a market rally in the run-up to the election signal a potential Mitt Romney victory because of investor perception that Republicans are friendlier to Wall Street than Democrats? People vote their pocketbooks, according to conventional wisdom — or rather, they vote their portfolios, especially in the aftermath of the Great Recession of 2007 through 2009, which took a large bite out of virtually all investments.

This year’s entry in the presidential-election-predictor sweepstakes is a study from the Socionomics Institute that looked at data from every US presidential re-election campaign back to George Washington’s in 1792. Their conclusion: The best single predictor of presidential re-election results is the percentage change in the stock market during the three years preceding election day — not unemployment, inflation, gross domestic product or other variables.¹ Here are some notable examples supporting their findings:

Wall Street and Presidential Winners and Losers
Incumbent President	Election Year	Three-Year Market Change1 (%)	Election Result
Thomas Jefferson	1804	82.63	Landslide win
Martin Van Buren	1840	-19.61	Landslide loss
Herbert Hoover	1932	-77.37	Landslide loss
Bill Clinton	1996	63.82	Landslide win
Ronald Reagan	1984	41.63	Landslide win

1 The three-year period is measured from Oct. 31 three years prior to a presidential election through Oct. 31 of the election year.

Source: Socionomics Institute, 2012. Used with permission. Past performance cannot guarantee comparable future results. The stock market is represented by the nominal Dow Jones Industrial Average. a price-weighted index of the 30 largest, most widely held stocks traded on the New York Stock Exchange, and the inflation-adjusted Dow Jones Industrial Average (DJIA/PPI). An investment cannot be made directly in an index. Returns reflect the reinvestment of dividends.

To view the complete study, please visit papers.ssrn.com/sol3/papers.cfm?abstract_id=1987160. This link will take you to a non-Invesco Internet site. Invesco has not reviewed the site and does not guarantee any claims or assume responsibility for the content.

Interestingly, the study results aren’t affected by whether voters owned stocks — underlying social mood, as measured by the stock market, indicates the election victor.

According to Robert R. Prechter, Jr., one of the study’s authors, stocks and voting are so tightly linked because people aren't any more rational with their voting than when they buy stocks. "We think most of the swing voters are moving on their feelings; in other words, the social mood and whether it's positive or negative," he says.¹ It will take several more presidential election cycles to determine whether this study morphs into conventional wisdom.

But consider this: The first chart above is based on the S&P 500 Index, while the second is based on the Dow Jones Industrial Average (DJIA). While the performance of both reflects the overall health of the economy, does one correlate more strongly with the results of presidential elections? Is the 30-stock DJIA as valid a predictor of election results as 500 stocks in the S&P 500 Index? There are lots of caveats with election-year predictors.

Investors, election years and conventional wisdom

Certainly the presidential election this November is important to investors because the outcome has implications for the federal budget, regulatory matters, tax and energy policy, health care reform and other important issues that will affect the stock market. But remember that politics is only one factor affecting stock prices, which also react to business cycles and interest rate changes, among other forces. And the market doesn’t like uncertainty, including the question mark of a presidential election.

While conventional wisdom about market politics is interesting, consider it nothing more than an addition to your market trivia collection. Remember that past performance — on which conventional wisdom is based — does not guarantee future results for investments or presidential elections. The key to investing successfully is to keep your eye on the long term no matter who wins the election.