Stock market response to presidential elections
Every four years, Americans go to the polls to vote for their next president. It is the world's most widely watched election - especially from the desks of institutional trading floors. That's because the stock market during elections does show some correlation. The phenomenon is known as the four-year election cycle and it is important to know about it when trying to trade the stock market response to presidential elections.
In this article, you will learn:
- The correlation in the stock market during elections.
- How to trade the stock market response to presidential elections.
- The ins and outs of the four-year election cycle.
- How to use Contracts for Difference (CFDs) to trade long and short no matter what happens during the elections.
- How to get started with a FREE demo trading account from Admiral Markets UK Ltd to practice your ideas and theories in a virtual, risk-free trading environment!
Why focus on the stock market during elections?
If you are not familiar with how stock markets operate, the most important element to understand is that it is a place where investors buy and sell shares of publicly listed companies like Apple, Facebook and Nike. As a public company's main aim is to generate profits to its shareholders, investors spend a lot of time trying to find which businesses are going to perform well in the future so they can also 'buy-in' and profit too. This could be in the form of a rising share price as the value of the company increases or dividend payments which most companies provide four times a year.
While investors will look at corporate earnings, product launches and financial metrics, like the price to earnings ratio, to determine good quality companies to invest in, there are external events that also have an impact. For instance, the four-year election cycle shows a correlation between the stock market during elections, albeit not all the time.
Markets are always wary of change. New governments have new ideas which can affect employment, tax and regulation among other things. Any significant changes can have an impact on corporate earnings. However, while some companies may benefit from any changes, some may not. Therefore, many people believe the effect on the stock market during elections can be balanced out.
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The stock market response to presidential elections
The four-year election cycle theory was first developed by Yale Hirsch, a prominent stock market historian. Many other global macro fund managers have also spent time analysing the stock market performance during election years.
However, generally speaking, most analysts come to the conclusion that overall the first two years of a presidential term tend to be the weakest with the last two years can provide well-above-average returns.
One reason for this is that the first two years of a term is filled with new ideas that can take some time to work out and filter through to the economy. During the last two years, the incumbent party focuses more on re-election, thereby setting an agenda and policy that is more favourable to the market and people's pension portfolios.
According to Jurrien Timmer, the director of global macro for Fidelity Management, the most interesting aspect to the four-year election cycle is that any differences in the first two years have disappeared by the fourth year. This is also partly confirmed by the Dow Jones Industrial Average's percentage gain from 1949 to 2019 during each step of the four-year election cycle: post-election, mid-term, pre-election and election year, as shown in the image below:
Source: Jeffery Hirsch
Some analysts have even taken this theory and tested it from 1789! For example, Timmer has analysed the monthly data from 1789 using a mix of the S&P 500 and Dow Jones Industrial Average stock market indexes. What is interesting to note here is that the pattern still holds true. The first two years of a presidential term are generally the weakest while the last two years are generally the strongest. This can be seen in the red bar chart diagram below:
Stock market reaction to presidential elections
In the chart below, the red lines indicate the most recent US presidential elections. While not all election years have ended in profit, more have than not - which is line with the long-term data analysis discussed above. This is because of the impact of events such as the 2008 financial crisis and the 2000 tech bubble.
In the chart of the S&P 500 index below, the red lines indicate the most recent presidential election dates. This enables us to see the stock market before and after elections:
Source: Admiral Markets MetaTrader 4, SP500, Monthly - Data range: from 1 January 2001 to 25 May 2020, accessed on 25 May 2020 at 8:45 am BST. - Please note: Past performance is not a reliable indicator of future results.
The most recent red line on the chart shows the Trump vs Clinton 2016 presidential election. The year ended with an 11.9% gain as the long-term analysis suggests. However, interestingly, the next year was not weak and actually continued to outperform historical averages. This is because Donald Trump announced business-friendly policies such as corporate tax cuts. This helped fuel a stock market boom for 2017 before a down year in 2018.
Here is how the stock market performed during other election years:
% Return S&P 500 Index
Donald Trump vs Hilary Clinton
Barack Obama vs Mitt Romney
Barack Obama vs John McCain
George W Bush vs John Kerry
George W Bush vs Al Gore
Bill Clinton vs Bob Dole
Bill Clinton vs George H W Bush
How to trade the stock market during elections
The bias for the stock market to rise in the last two years of the four-year election cycle is just one aspect to focus on. It would be wise not to only focus on this one bias. Analysing the overall economic conditions, strong performing sectors and company fundamentals should also play a big part in any trading or investing decision.
However, there are a variety of ways traders and investors can use this information. Some are highlighted below:
1. Invest in the strongest sectors and companies in year three and four
If the overall stock market does indeed move higher in year three and four of the four-year election cycle, identifying the strongest sectors and companies within them could lead to some very strong trends. For example, banks like JP Morgan and Bank of America may perform well if new policy announcements offer looser regulation.
The Admiral Markets Contract Specification page allows you to search for companies within different industries, as shown below:
2. Invest in the overall stock market index in year three and four
Instead of picking out individual stocks, investors may choose to invest in the overall stock market index like the S&P 500 index. This can be done by investing in stock market index ETFs. For example, the Vanguard S&P 500 UCITS ETF aims to track the performance of the S&P 500 index and is favoured by legendary investor Warren Buffett.
You can view the different ETFs available to trade and invest in from the MetaTrader 5 trading platform provided by Admiral Markets. Simply open the Market Watch window (Ctrl+M), right-click and select Symbols. This will also provide other details such as the contract size and opening and closing hours of the market.
A screenshot of the Symbols window in the MetaTrader 5 trading platform.
3. Short the weakest sectors and companies in year one or two
As the general trend is for lacklustre gains in the first two years of the presidential election cycle, traders may look to identify the weakest sectors from the election in year four. If a sector cannot rally on any new policy changes from a new presidential term, investors may move their money elsewhere causing a decline in some sectors. Identifying companies within these sectors and using products like Contracts for Difference (CFDs) can help traders to 'short a stock' and potentially profit from a falling market.
To place a buy or sell trade on any market simply right click on the chart in your MetaTrader 5 trading platform provided by Admiral Markets and select Trading and then New Order. Alternatively, press F9 on your keyboard.
A screenshot of a trading ticket in the MetaTrader 5 trading platform.
4. Wait for a trend to develop in the stock market index and trade it!
Most retail traders would opt to wait for a trend to be established and then trade in the direction of that trend. If it can develop at the right time of historical biases based on the four-year cycle it could lead to a longer-term trend which may provide short-term traders ample opportunities to trade in and out of the market.
Why trade the stock market during elections with Admiral Markets?
- Trade with a well-established, regulated company which includes regulation from the UK's Financial Conduct Authority.
- Benefit from a negative balance protection policy, to protect you from adverse movements in the market.
- Access the fastest and most popular online trading platform called MetaTrader which you can use on PC, Mac, Web, Android and iOS operating systems and is provided for free by Admiral Markets UK Ltd.
- Open an Invest.MT5 investing account to buy shares and ETFs from 15 of the largest stock exchanges in the world.
- Open a Trade.MT4 or Trade.MT5 trading account to trade via CFDs (Contracts for Difference) in order to go long and short a market to potentially profit from rising and falling markets.
Get started today by opening a free demo trading account so you can trade in a virtual trading environment until you are ready to go live!
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