Every four years U.S. citizens head to the polls (or mailbox) and vote for the next president and a vision for the country.
While the peaceful transition of power is a cornerstone of American democracy, that doesn’t necessarily mean the process is easy. The campaign cycle brings out raw emotions as policies and principles are fiercely debated. As November draws closer, the rhetoric, uncertainty and intrigue are only amplified.
The gravity of the moment also seeps into markets. You’ll read countless analyses about how a candidate would impact the markets and economy. Stocks can be highly sensitive to polls or proposals from one day to the next, from one sector to another. As the election captivates the nation, it’s easy for investors to begin “overweighting” politics in their portfolios.
However, we implore investors not to let political intrigue overwhelm their investment decision-making process in the weeks ahead. Politics and policy should always be factored into an overall investment equation, but presidential elections are emotionally charged affairs that can cause investors to overestimate the impact a president can have on market returns. No doubt, presidents and their administrations can nudge the economy in one direction or the other, but they are rarely an absolute positive or negative. The multifaceted, complex, $20 trillion U.S. economy is like a massive tanker ship that doesn’t easily change directions. It’s an extremely large, de-centralized, capitalistic system, functioning within a democratic society, and that makes it hard to dislodge its natural trend rate of growth.
Every economy undergoes natural cycles of expansion and contraction that, quite frankly, are hard to interrupt. Rather than any single political platform, the point in the business cycle when a president assumes office, along with stock valuations at the time, can have an outsize influence on market returns during a president’s tenure in the White House.
THE OUTPUT GAP
Over long periods of time, the U.S. economy expands at a natural trend rate of growth — think of it like the speed limit. However, the economy doesn’t drive at a consistent speed from one year to the next. Instead, it drifts through periods of expansions followed by contractions, sometimes racing well above its speed limit or cruising well below it. This movement around its long-term trend, or speed limit, is known as the business cycle (a single cycle contains one boom and one bust), and history shows this is a natural, inevitable process.
One way to gauge where we are in the business cycle is to look at the output gap. Quite simply, this is the difference between the actual output of the economy, and its potential output. When the gap is positive (the economy exceeds the speed limit), the economy is humming along above it’s expected capacity, which means companies are having a tough time keeping up with demand. A negative output gap (the economy driving under its speed limit) means the economy is sluggish and operating below its expected capacity.
And, as it turns out, the output gap (i.e. the business cycle) and stock valuations are pretty good indicators of how the market will fare under a president, regardless of party affiliation.
POLICY PROWESS OR GOOD TIMING?
If the output gap is positive (late in the cycle) when a president takes office, the subsequent four-year returns tend to be muted or even negative. When Democrat Lyndon B. Johnson took office in 1964, the output gap was a modest 0.35, and the annualized return during his term was 8.61 percent. Four years later, when Republican Richard Nixon took office in 1968, the output gap was at a very high 2.48 and the annualized market return for his four-year term was about 6.68 percent. Overall, presidents who assumed office late in the business cycle, Republican or Democrat, saw the market’s annualized four-year returns average 6.73 percent.
Another indicator: Late in business cycles, market valuations tend to be high. Investors, on average, are paying more for every dollar of earnings because they expect earnings growth to continue. When George W. Bush became president in 2000, months before a recession, average valuations were at a historically pricey 31 times inflation-adjusted earnings. Average market returns during his first term, as a result, were -0.52 percent. Typically, the end of the business cycle comes when the economy runs too hot, which triggers inflation and pushes the Federal Reserve to raise rates. That slows economic activity, and so often ushers in a recession, and the output gap turns negative.
Eventually, a new cycle begins. Low interest rates fuel spending and investments, demand starts to recover from its trough. Slowly but surely, the economy starts to accelerate back to its speed limit, or natural growth trend.
Now, let’s flip to presidents whose terms began earlier in the business cycle. In 2008, when Democrat Barack Obama was elected, the output gap was -4.17 (very early cycle), and the market returned an annualized 14.56 percent. Valuations were also at a historically low 15 times inflation-adjusted earnings. When Republican Ronald Reagan was elected to a second term in 1984 (mid-cycle), the output gap was -1.55 and the four-year, annualized market return was 17.69 percent. Valuations when Reagan took office were also relatively modest at 17 times inflation-adjusted earnings.
Overall, when a president took office early- or mid-cycle, the average, annualized four-year market return was 14.23 percent and 10.61 percent, respectively. They also inherited markets valued at 20 to 21 times inflation-adjusted earnings, versus 26 times inflation-adjusted earnings for late-cycle presidents.
Broadly speaking, the data show that presidents aren’t the sole factor when it comes to market returns.
In case you were wondering: Whoever becomes president this year will likely assume office with the output gap hovering around -6, seemingly "early cycle”. However, market valuations are hovering at a historically elevated, “late cycle”, inflation-adjusted price-to-earnings ratio of 26. Keep in mind, the Federal Reserve has no desire to raise rates soon (the typical harbinger of recession), which should provide confidence in the years ahead.
Regardless, through Democrat and Republican administrations, long-term market returns have been positive.
LIFE IS UNPREDICTABLE, ESPECIALLY FOR A PRESIDENT
We’d be remiss to not point out that even an administration’s best-laid plans can be interrupted by a crisis or a global event. We’ve certainly seen that happen during the coronavirus pandemic, but we’ve seen it happen in the wake of 9/11, the Great Recession and a host of other trials and tribulations throughout history. These are gamechangers that put administrations on the defensive, forcing them to react rather than implement a policy vision.
We do acknowledge that presidents and administrations can shift some growth toward certain sectors, industries or companies with their policies. But even within specific sectors of the economy, variable and secular trends can overpower a president’s actions. For example, much has been made of President Donald Trump’s financial deregulation — specifically in the banking industry. Bank stocks, however, have dramatically underperformed the market during his tenure. Indeed, since election day in 2016 the KBW Bank and Regional Bank Index have produced negative returns. Perhaps there is a bigger secular trend driving the industry?
VOLATILITY, BUT A RETURN TO CALM
Of course, this all isn’t to say that policy and politics don’t matter. You should always account for these factors in your broader investment calculus and financial plan, even when there isn’t a major election. But the nuanced point we want to convey is that you should resist the urge to place added significance on politics, at least when it comes to market returns, simply because it’s a presidential election year. While the candidates and issues change every four years, we believe the backdrop and advice remains the same: Stick to a long-term financial plan that harnesses growth through diversified investments while also managing risk.
In the weeks following the election in November there will probably be some short-term turbulence as markets digest the results. However, we believe that most political outcomes this fall will ultimately yield relatively calm markets going forward. A Democratic sweep, or contested election that puts results in doubt, could amplify volatility. However, the Federal Reserve and its shift toward incredibly accommodative policies has had an immense impact on supporting markets. That’s been the case for some time, and we don’t see that changing in the future — no matter who is elected. We also don’t see much changing when it comes to federal spending either — neither political party has shown interest in belt tightening.
Even if there are a few surprise outcomes, any sell-off, we believe, would be a “kneejerk” reaction. We encourage you to not follow the herd if this happens. Over time, the market should eventually digest the new policy backdrop and likely move higher as uncertainty lifts and the focus shifts to what is next.
Opinions are as of the date of publication and subject to change. All investments carry some level of risk, including loss of principal. Indexes referenced are unmanaged and cannot be invested in directly.