What We Can Learn From The Stock Market's Reaction To A President Trump
As it turns out, whether markets -- specifically stocks -- continue to fall or begin to rise over the next few days can be a useful predictor for how they will perform in the months and even years to come. In the case of the 2016 presidential election, investors will decide whether they think Trump will be good or bad for the economy - -and more importantly their investments -- as the 45th president.
The rest of us, investor or not, would be well-advised to pay attention. In general, as you might expect, markets tend to rally if investors think the election winner will be good for their investments and drop if they deem otherwise. Essentially, they're all just making bets on the future -- some short term, some longer term.
In particular, they may turn bullish and buy more U.S. Research I published in 2014 offers evidence that the stock market's early assessment tends to be a good predictor of how it will perform in the near future. In my study, I examined market returns for the Dow Jones Industrial Average (DJIA) -- which includes 30 of the best-known U.S. Microsoft and Boeing -- covering 29 presidential elections from 1896 to 2011. I found two key pieces of evidence that may drive investors' stock portfolio performance both in the short term and the long term.
First, how the market reacts the day after the election appears to be an indicator of how it will perform for the remainder of the election year. In those 29 presidential elections I examined, when the market "approved" of the outcome by rallying the day after the election, stocks returned an average of about 3 percent over the rest of the year. When stocks initially dropped, the market lost an average of about 2 percent during the period. My second key finding was that markets tend to change their mind in a new president's second year in office.
That is, in cases where stocks rallied for the first three days after an election, the market seems to consider the initial move an "overreaction," and vice versa. Specifically, the DJIA lost an average of about 2.5 percent in a president's second year if he got a victory boost during those three days.
When the president-elect was initially punished by investors, stocks returned about 12.5 percent in his second year. The reason for this anomaly seems straightforward. Media attention leading up to the election induces extreme beliefs in voters, including investors, which are reflected in trading decisions as soon as the results are known. So if the market reacts negatively to the election's outcome and the president turns out to be not as bad as expected, then the market recovers.
The opposite behavior occurs when the market reacts positively to the election's outcome and apparently, this behavior happens frequently. More broadly, these findings seem to fit into a well-known phenomenon called the presidential election cycle, referring to the four years following a new president taking the oath of office. Going back to at least the 1960s, the second half of a president's term, especially the third year, has almost always outperformed the first half.
For the last 14 election cycles, returns in the third year of a term have averaged about 16 percent, double the average during every other year. That means for this year's election, 2019 should be a good one for investors regardless of how markets react in the coming few days.
Some have argued the reason is that going into a presidential election year, the president is motivated to keep his party in power. Hence, he has an incentive to implement fiscal policies designed to give the economy a boost, which is usually good news for a company's bottom line, resulting in positive stock returns.
