How do Political Conditions Affect the Stock Market?

Politics and Stock Market

Politicians are responsible for policy decisions that affect certain parts of the business, for instance, change in taxes on imports and exports, lifting or cutting the interest rates, subsidizing a particular product, etc. In some extreme cases, the political shocks can lead to major swings in stock prices. These examples are decisions on war, important information leaks, bribery or other scams, etc.

Generally, the more stable the political situation is in the country, the more favorable situation exists for the stock market investors.

“Political uncertainty commands a risk premium whose magnitude is larger in weaker economic conditions. It makes stocks more volatile and more correlated, especially when the economy is weak” wrote Lubos Pastor in his “Political Uncertainty and Risk Premia” research paper.

Presidential Elections

It has been historically agreed by many economists, that the US elections have an impact on stock market and the election cycles correlate with the market returns.

According to the popular “presidential election cycle theory”, financial markets tend to decline in the year following a presidential election.

A common misconception is that stock prices tend to increase when a more business-friendly party wins. But according to the historical data, markets actually are positively affected under Democratic presidents than Republican ones. The Dow Jones Industrial Average had a return of 82.7% during Democratic presidential administrations, in comparison to 44.7% under Republican ones.

However, it is also important to mention that the policy changes can take time to have an effect on the economy. So, for example, if we examine the same effect, but with a one year delay, the picture is totally the opposite: during Republican presidents the return was higher in comparison to Democratic ones.

It is important to remember that elections, new policies or news about certain policies themselves doesn’t affect the stock prices, rather the decisions that investors make based on those news influence the prices. So investors’ actions will be affected by the candidate’s policy or his/her views on the economy and the steps he/she considers to implement when elected.

Obama’s Example

After Barack Obama’s elections markets started to plunge, which was, according to many analysts, the investors’ fear of Obama’s policies. However, as the markets started to recover from 2009 with a bull run that has not yet ended, this argument was no longer valid. Obama’s election coincided with the financial crisis and investors’ heavy selling was nothing to do with his policies.

Investors have to distinguish the real impact of elections or the new policies on the stock market from other macro factors affecting the economy.

To summarize, investors have to take the politics and particularly elections into consideration when forming opinions about the stock market and certain stocks, but relying too much on the short statistics of US elections that may not show the real significance of correlations, is not advisable. The sample we discussed includes only 19 presidents, which is a very small sample size to rely on.