Every four years, the twist and turns of the U.S. elections invariably drive volatility in the markets. The force behind the increased volatility rarely stems from the election outcomes themselves, but the uncertainty leading up to the election. While markets are extremely efficient at pricing in known factors, it is the combination of unknown factors and perceived uncertainties that fuel instability and volatility. Though each election cycle comes with its own unique dynamics, certain issues seem even more pressing in the face of this global pandemic. Some of the key questions on the minds of investors:
Will there be more stimulus checks?
Is the economy poised for further shutdowns?
Is the U.S. national debt sustainable?
Will my taxes go up?
And the list goes on. Mounting uncertainty and market volatility go hand in hand.
Volatility: The Known Unknowns
The VIX index, often referred to as the fear-gauge, provides a measure of market risk and investor sentiment. Specifically, the VIX reflects expectations for stock market volatility over the next 30-days. Evidenced by the chart below, each election cycle going back to 1992 has experienced a rising VIX index in the months preceding election day. Over the past month there has been a continuation of this historical pattern, with the spot VIX rising about 6 points over the course of October. This data indicates the exacerbated volatility during election years is the norm, not the exception. This allows investors to be proactive rather than reactive. Armed with properly calibrated expectations, investors can prepare for the turbulence ahead.
Does Red or Blue Equal Green?
In the world of investing, there are very few outcomes or events that are consistently predictable. Election outcomes, and the ensuing market responses, are no different. Major polls can provide valuable insight into which direction voters are leaning at any point in time. However, the credibility and accuracy of these polls have come into question at times. Since 1950, the latest poll before election day has generally been correct, but failed to predict the winner in 1976, 2012, and 2016. Yet, even if election results were predictable with certainty, translating that into useful information from an investment decision making standpoint would prove to be a much taller task. In general, Republican policies are thought to be more business-friendly, hence more stock market friendly. This is consistent with findings from a recent report issued by YCharts which shows the S&P 500 Index of stocks typically outperforms during the periods of time between election and inauguration when the president-elect is a Republican. However, there is balance, i.e. on average markets have performed better during times when a Democrat is leading the White House. The YCharts report also attempts to determine whether the markets prefer the incumbent, or challenger. Historically, the markets initial reaction is more positive when the incumbent president is re-elected than when the challenger wins. However, they found that over president’s full terms in office, the market has outperformed under the scenario where challengers unseated an incumbent president.
So, What Does this Tell Us?
Unfortunately, not a whole lot. Throughout history, there is very little evidence that markets explicitly prefer one political party over the other. There is always more at play than meets the eye. When taken at face value, the potential impacts of various ideas and promises presented by politicians on the campaign trail appear to be clear-cut. However, bureaucracy and compromise often shape the reality of these ideas, resulting in something quite different than one may expect. Likewise, markets do not always behave as conventionally expected. For Example: defense and so-called sin stocks were widely expected to suffer under President Barack Obama. But over those eight years, defense as a sector outperformed, with one top name outpacing the S&P 500 by 400% and another by 100%. The leading tobacco stock bested the index by more than 250% (Blackrock). Taxes can also be explored. During the Trump administration, federal tax rates came down dramatically across the board. By contrast, Biden has proposed increasing the top tax rate for corporations and individuals alike, while also hiking taxes on investment gains and income. In theory, higher corporate tax rates should deliver a blow to corporate earnings, a major driver of stock prices. As earnings decline, the stock market should follow. However, Fidelity sector strategist Denise Chisholm notes that during the 13 previous instances of tax increases since 1950, the S&P 500 delivered higher than average returns.
The key takeaway here is that the political party in power is only one of many variables that impact markets. Significant events such as the 2008 Financial Crisis and the Covid-19 pandemic are well beyond the control of any political party. Short-term volatility or eventual election outcomes should not impact investment plans. Over the long-term, markets are driven by fundamentals, not politics, and at HKFS, our investment horizons extend far beyond election cycles and presidential administrations.