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How elections move markets in 5 charts

How elections move markets in 5 charts

September 25, 2020

How much do elections impact the stock market and portfolio returns?

Should elections even matter to long-term investors in the first place?

These are the questions investors and financial professionals are facing as we approach November 3rd. To provide answers, we’ve analyzed more than 85 years of data and identified five ways that elections influence markets and investor behavior.

1) Markets have tended to predict election results

Chart shows the S&P 500 Index’s average returns during election years between 1936 and 2016, separated into lines showing years when the incumbent party won and years when the incumbent party lost. In years when the incumbent party won, the line mostly increases throughout the year. In years when the incumbent party lost, the line increases for most of the year until around August when it starts to level off and eventually decreases before increasing again in November. Source: Strategas. Returns are indexed to 100 on January 1 of each election year. Returns are in U.S. dollars. The shaded region approximately shows the three-month period prior to Election Day.

A simple stock market metric has correctly predicted the winner in 20 of the last 23 presidential elections since 1936 — a track record that might make even the top pollsters jealous. If the S&P 500 Index is up in the three months prior to Election Day, the incumbent party usually wins. If markets are down during that period, the opposing party typically claims victory.

Why is this? It’s because equities tend to look ahead and “price in” uncertainty — including that caused by an upcoming election.

When the stock market and the economy are strong, there is usually less motivation for a change in leadership. In those years, stocks may not need to discount the uncertainty, which often allows stocks to continue rising, further bolstering the incumbent’s chance of reelection.

When the political and economic climate are more challenging, there is a greater chance that the opposing party will win. The market discounts the added uncertainty of the election outcome and what policy changes may occur, which can lead to higher volatility.

What does this mean for 2020? As of September 15, the S&P 500 is up 3% since August 3rd (three months prior to Election Day) and 5% year-to-date. In more normal times that would favor the incumbent, but today’s shaky economy offers a different story. Since 1912, only once has a president been reelected if he oversaw a recession within two years of the election. While this trend may be interesting, investors shouldn’t use it as an excuse to try to time markets. Historically, whether the incumbent wins or loses, election volatility has usually been short-lived and quickly given way to upward moving markets.

2) Gridlock or sweep? Equities have gone up either way

Chart showing the S&P 500 Index average annual return from 1933–2019 under three scenarios of party control of the White House and Congress. The unified government scenario had a 10.0% return. The unified Congress with the president in the other party scenario had a 7.4% return. The split Congress scenario had a 10.4% return. Sources: Capital Group, Strategas. As of December 31, 2019. Unified government indicates White House, House and Senate are controlled by the same political party. Unified Congress indicates House and Senate are controlled by the same party, but the White House is controlled by a different party. Split Congress indicates House and Senate are controlled by different parties, regardless of White House control.

One of the biggest concerns investors have this election cycle is the possibility of a Democratic sweep of the White House and Congress. Many assume this so-called “blue wave” will lead to a reversal of policies like deregulation or the Tax Cuts and Jobs Act of 2017. While it’s true that a new party typically brings its own policy agenda, assuming such an outcome will lead to meaningfully lower stock prices is probably over-simplifying the complexities of stock markets.

History shows that stocks have done well regardless of the makeup of Washington. Since 1933, there have been 42 years where one party has controlled the White House and both chambers of Congress at the same time. During such periods, stocks have averaged double-digit returns. This is nearly identical to the average gains in years when Congress was split between the two parties. Historically the “least good” outcome has been when Congress is controlled by the opposite party of the president. But even this scenario notched a solid 7.4% average return.

What does this mean for 2020? This year’s election will almost certainly end in either a unified government under a blue wave or a split Congress, which could happen with either a Trump or Biden victory. Voters may have a strong preference, but investors should take comfort that both scenarios have historically produced strong equity returns.

3) Markets have trended higher regardless of which party wins the election

The chart shows the growth of a hypothetical $10,000 investment in the S&P 500 Index from March 4, 1933, to August 31, 2020. It also shows the time periods when the U.S. president was a Democrat or a Republican. The ending value is $154,998,429. Sources: Morningstar, Standard & Poor’s. Dates of party control are based on inauguration dates. Values are based on total returns in U.S. dollars. Shown on a logarithmic scale.

Politics can bring out strong emotions and biases, but investors would be wise to tune out the noise and focus on the long term. That’s because elections have, historically speaking, made essentially no difference when it comes to long-term investment returns.

Which party is in power hasn’t made a meaningful difference to stocks either. Over the last 85 years there have been seven Democratic and seven Republican presidents, and the general direction of the market has always been up. What should matter more to investors than election results is staying invested.

What does this mean for 2020? Some have called the 2020 election the most important in our lifetime. But that has been said about previous elections and will be said again about future elections. This year has been unique in countless ways, but a look at past election cycles shows that controversy and uncertainty have surrounded many campaigns. And in each case the market continued to be resilient. By maintaining a long-term focus, investors can position themselves for a brighter future regardless of the outcome on Election Day.

4) Investors often become more conservative in election years

The chart shows the average net fund flows into equity funds and money market funds in presidential election years and in the year after an election, using data from 1992 through 2020. In presidential election years the average net equity fund flow has been $76 billion, and net money market flows have been $176 billion. In the year after an election, average net equity fund flows have been $168 billion, and net money market flows have been $36 billion. Source: Morningstar. Includes mutual funds and ETFs. Values based on U.S. dollars. Equity funds include U.S. and international equity funds. 2020 data is year-to-date through July 31, 2020.

It can be tough to avoid the negative messaging around election coverage. And it’s natural to allow the rhetoric of political campaigns to make us emotional. History has shown that elections have had a clear impact on investor behavior, but it’s important that investors don’t allow pessimism to steer them away from their long-term investment plan. 

Investors have poured assets into money market funds — traditionally one of the lowest risk investment vehicles — to a much greater degree in election years. By contrast, equity funds have seen the highest net inflows in the year immediately following an election.

This suggests that investors want to minimize risk during election years and wait until any uncertainty has subsided to revisit riskier assets like stocks. But market timing is rarely a winning investment strategy, and it can pose a major problem for portfolio returns.

What does this mean for 2020? This trend accelerated in 2020: Through July 31, net money market flows increased $546 billion while net equity fund flows decreased $36 billion. Of course, part of this year’s flight to safety was related to the pandemic-induced recession and not the election. Still, equity funds saw their largest monthly outflows in July, indicating that investors are remaining conservative ahead of the election.

5) Moving to cash in election years can reduce long-term portfolio returns

The chart shows results of three hypothetical $10,000 investment strategies that could be used during an election cycle, using data from 22 election cycles since 1932. In the fully invested strategy, the average ending value after a four-year holding period was $15,866. It was the best outcome in 14 cycles and was the worst in six cycles. The consistent contribution strategy had an ending value of $15,729. It was the best outcome five times and was never the worst. The sitting on the sidelines strategy had an ending value of $14,914. It had the best outcome three times and the worst outcome 16 times. Sources: Capital Group, Morningstar, Standard & Poor’s. The three hypothetical investors each have $10K to invest during an election cycle and are invested in a combination of equities and cash at all times. Fully invested is always fully invested in equities. Consistent contributions starts with $1K in equity and $9K in cash. At the start of each of the next nine months, this investor reduces cash by $1K and makes a $1K contribution to equities, after which they will have made the full $10K contribution to equities. Sitting on the sidelines is entirely invested in cash during the first year. At the start of the second year, this investor reduces cash by $10K and makes a $10K contribution to equities. S&P 500 Index used for equity returns and reflects the reinvestment of dividends. Ibbotson SBBI US 30-Day Treasury Bill Total Return Index tracks the return, including the reinvestment of interest, of short-term U.S. government debt obligations with a maturity of approximately one month, and is used as a proxy for cash returns. Returns and portfolio values are calculated monthly and in USD. Analysis starts on January 1 of each election year and reflects a four-year holding period.

What has been the best way to invest in election years? It isn’t by sitting on the sidelines.

To verify this, we looked at three hypothetical investors, each with a different investment approach. We then calculated the ending value of each of their portfolios over the last 22 election cycles, assuming a four-year holding period.

The investor who stayed on the sidelines had the worst outcome 16 times and only had the best outcome three times. Meanwhile, investors that were fully invested or made monthly contributions during election years came out on top. These investors had higher average portfolio balances over the full period and more frequently outpaced the investor who stayed in cash longer. These results reflect four-year holding periods, but the divergence would be even wider if compounded over longer time frames.

Sticking with a sound long-term investment plan based on individual investment objectives is usually the best course of action. Whether that strategy is to be fully invested throughout the year or to consistently invest through a vehicle such as a 401(k) plan, the bottom line is that investors should avoid market timing around politics. As is often the case with investing, the key is to put aside short-term noise and focus on long-term goals.

What does this mean for 2020? It’s too early to know what the impact of this year’s flight to cash will be on investors’ long-term portfolio returns. But with the S&P 500 soaring over 50% since the March bottom and net equity selling continuing throughout the year, it is safe to assume many investors missed at least some of this powerful equity rally and remain on the sidelines ahead of the November election.

Securities offered through Securities America, Inc., member FINRA/SIPC. Advisory services offered through Securities America Advisors, Inc. William R. Pintaric & Associates and Securities America are separate entities. 

Written by American Funds  for distribution by David Pintaric.

Securities America and its advisors do not provide tax advice. Please consult with your tax professional regarding your individual tax situation.