Posted by on Oct 25, 2012 in Articles & Advice, Blog, Columns, Featured |

Image Credit: Christophe Vorlet

By Jason Zweig |  Oct. 22, 2012 12:28 p.m. ET

Over the next few weeks, investors will be bombarded with commentary about how the outcome of the presidential election will influence the financial markets.

Before you even consider changing your portfolio based on the expected—or actual—results of the election, it’s vital to analyze the conventional wisdom first.

Is gridlock good—that is, should investors root against having the same political party control both Congress and the White House? Who is better for stock and bond returns: Republicans or Democrats?

Most of the answers you are likely to find are propaganda or wishful thinking; many are flat-out wrong. What matters are changes in interest rates, not which party passes through the White House gates.

Since 1926, when reliable stock-market data began, the United States has had 15 presidents and nine elections in which control of the White House passed from one party to the other. That’s a small sample. So you should take any statistical conclusion about the relationship between presidential election results and financial returns with a grain of salt the size of the Capitol dome.

Such caveats won’t stop pundits from speculating. One of their most prevalent beliefs: Gridlock is good for the stock market. (A Google search returns 135,000 hits on the phrases “gridlock is good” + “Wall Street.”) And a divided Congress is what many political forecasters expect, with Pres. Obama winning re-election, the Democrats keeping the Senate and the Republicans retaining the House.

A hard look at the evidence, however, shows that “gridlock isn’t good for stocks,” says Robert Johnson, a finance professor at Creighton University in Omaha. In a working paper that covers 1965 through 2008, he and his colleagues found that gridlock had no effect on the returns of the big companies represented by the Standard & Poor’s 500-stock index. Small stocks (as measured by Dimensional Fund Advisors’ small-company portfolios) returned an average of 21 percentage points less in years when Washington was in gridlock than they did when Congress and the White House were under common control.

Bickering does have benefits: Corporate bonds have returned an annual average of nearly nine percentage points more in gridlock years than in years of governmental harmony. “Gridlock reduces the chances of the initiation of major government programs, which can be inflationary” and harmful to bond prices, says Prof. Johnson’s colleague Gerald Jensen, a finance professor at Northern Illinois University.

Which party controls the White House certainly appears to matter. Since 1926, the Standard & Poor’s 500-stock index has gained almost exactly twice as much under Democratic presidents as under Republicans, according to quantitative stock analysts Pankaj Patel and Joseph Handelman of Credit Suisse. Stocks have racked up an average annual return of 15.4% when a Democrat is in the White House, versus 7.8% under Republican presidents.

That doesn’t mean stocks are bound to boom if Pres. Obama is re-elected. But as Adam Parker, chief U.S. equity strategist at Morgan Stanley, points out, a presidential election hasn’t resulted in a Democrat in the White House with a Congress divided along those lines in at least 112 years. So the historical averages might not even matter.

The dominance of stock returns under Democrats might be a subtle kind of statistical illusion. The research by Prof. Johnson and his colleagues suggests the Federal Reserve’s monetary policy is far more important.

Since 1965, according to the study, large stocks have returned an annual average of nearly 12 percentage points more when the Fed was cutting rates than when it was raising them. (The researchers started their analysis then because 1965 was the dawn of modern Fed policy.) Over the same period, the difference in stock returns under Democratic versus Republican presidents was less than seven percentage points; a statistical analysis shows that the effect of Fed policy dwarfs the impact of presidential party.

In short, Fed policies matter more than party politics. Democratic presidents happened to benefit disproportionately from periods when the Fed was cutting interest rates—which is rocket fuel for stock returns. That’s especially true for small stocks, which have returned 26 percentage points more, on average, in years when the Fed was cutting rates rather than raising them. Says Prof. Johnson: “There’s no systematic relationship between the party of the president and asset returns.”

What does all this mean for investors? You should cast your vote based on what you believe will benefit the country, not what pundits think will benefit your portfolio. Don’t let anyone scare you into making major investment changes because one party or the other takes the White House. No matter who wins, it’s the direction of change in interest rates that will make the biggest difference to the returns of the financial markets.

Source: The Wall Street Journal