How stocks behave before and after elections

How the market reacts to presidential elections boils down to confirmation bias, uncertainty and the market’s natural job of pre-pricing. Let me explain.

Confirmation bias, simply said, is the behavioral, psychological tendency we all have to see things confirming our prior views and being blind to evidence that contradicts our views. There are few areas in life where confirmation bias is stronger than politics. Most everyone is sure they’re right.

Political confirmation bias sparks semi-predictable market movements during presidential election years and inaugural years. Understanding this gives you a sense of how stocks may move now and in 2021.

First, some general market stats on presidential election years: historical returns average 11.1%, with most of that gain occurring in the back half of the year. The year’s first half historically averages a modest gain of 1.1%. This year’s first half total return of -4% isn’t that different despite COVID-19 et al.

But how markets react to Democratic and Republican victories are very different and will likely surprise you, again, mainly driven by confirmation bias. It works like this:

The investor class overall leans right, roughly two to one. Most conservatives naturally think if former Vice President Joe Biden is elected, we’re on the wrong road (to socialism) faster than I can write—which will slam stocks. Those on the left typically think that if President Donald Trump wins, it’ll be just God awful—or worse.

As the election year progresses, these views get fully pre-priced into stock pricing because they’re not unique, commonly known and widely held. In past LinkedIn columns and for decades, I’ve written about the market’s job, which is to pre-price widely known information and opinions. Political views are no exception. They’re the rule, perfectly.

Republicans are generally viewed by investors as more business friendly, anti-regulatory and free market oriented. Democrats are typically viewed as more big government oriented and more pro-regulatory, which investors overall assume would undermine profitability and hence the stock market. Few disagree about that perception (although they may about the reality), beyond minor quibbling.

Hence, fear of a Democrat winning dampens election year returns, being pre-priced, when we elect them (with an average S&P 500 election year return of 7.4%). But the pre-pricing of a Republican POTUS victory heightens hopes to higher returns (with average gains of 15.2%).

But in inaugural years those dynamics flip flop. Democratic inaugural years are much better for stocks (average return of 16.2%) than Republican inaugural years (average return of 2.6%).

Markets are heavily moved by surprise and – surprise, surprise – Democratic presidents aren’t able to implement most of their ostensibly anti-business campaign promises so the surprise is positive, reversing most prior year fears. Just so, Republican victors are unable to deliver on most of their pro-business campaign promises and the surprise is negative, again reversing the election year hopes. Said simply, the Democrat can’t do as much as most investors feared and the Republican can’t do as much as they hoped.

Overall, total market performance of those two years together is very similar. The spread isn’t statistically enough to suggest one political party is better or worse for markets over the two years. It’s just when the returns come. Politically biased, almost no one likes to hear this. But it’s true.

I call this dynamic the “Perverse Inverse.” The nature of our three part, (Administrative/two-part Congressional/court challenge) governmental tripod-based system is that presidents can never, ever, ever do even a small percentage of what they flamboyantly promised while campaigning.

Again, if the Democrat, Biden now, is elected there should be lower returns through year end but higher returns from positive surprise next year when he won’t get as much done as feared and, hence, can’t be as bad.

Again, if the Republican, Trump now, is re-elected, there is a similar parallel function of higher returns soon but disappointment next year when he can’t be as pro-business as investors had hoped. 

The “Perverse Inverse” is, simply said: when we elect Democrats, election years tend to be worse for stocks, but inaugural years tend to be better. When we elect Republicans, election years tend to be better, but inaugural years tend to be worse.

In 2016 and 2017 it didn’t quite work out this way, and I said it wouldn’t, because in that year, as you recall, almost everyone and her grandmother was betting that if Trump was elected stocks would fall hugely. So, they didn’t. Trump was viewed then like investors often view the Democratic candidate, to be feared. Remember the overnight market that election night? Scary. But wrong. Trump turned out to be more of a conventional Republican in what he tried to do and could get done than people expected (one tax cut, lots of judicial and other appointments but mainly conventional ones, lots of little executive orders and some tariffs) so the fear abated and stocks did great in 2017.

This time Trump, despite his unconventional behavior, politically and otherwise, is seen as more of a full-fledged Republican ideologically on policy. More pro-business, anti big government, etc. So, markets are likely to treat him more like they normally do Republican presidential candidates.

Will what I call the “Perverse Inverse” apply again? Probably! Even with the bear market in March, this year’s stock market action in so many ways is actually archetypal and consistent with everything I’ve been saying here every month in past columns.

The stock market return from Jan. 1 of this year through June 30 was -4%, which is pretty close to a presidential election year’s average first half return, which I mentioned earlier is basically flat. 

Yet in an election with abundant hysteria, we still have this overriding feature that America’s constitutionally architected system won’t let whoever gets elected do nearly as much as some people hope and others fear. So, when you think about stocks, calm down. Always good advice.

How uncertainty falls during election years

Another factor to consider is uncertainty. Markets love falling uncertainty and hate rising uncertainty. The absolute level of uncertainty is relatively unimportant.

With presidential election cycles, you either have an incumbent of one party or the other or an open race. We have each in our history.

Now, we had one incumbent and an extremely wide open primary season on the other side. In any wide open primary season, aspirants make a lot of wild claims—many of which scare people. Over time aspirants get weeded out through primaries—to a more narrow set of wild claims. That’s uncertainty falling. The uncertainty falls further through the summertime nomination of the final nominees, the vice-presidential selections, announcement of a platform and the beginnings of what the race will actually look like. That’s after the conventions and this time, right now.

Uncertainty falls through year end. Politically, election years are irregular falling uncertainty—good for stocks. Early on you have rising uncertainty with all the yadda, yadda, yadda these aspirants spew. But that stuff narrows as the year progresses.

Sometimes, we get an “October Surprise” elevating uncertainty. But I have news for you: in November, we always get a winner. I say that as a joke, but it’s true. A winner provides reduced uncertainty.

Once elected you hear what this president says post-campaign. And that’s falling uncertainty, too. You learn what the president's cabinet will look like and what he will really push and not push--all falling uncertainty. Markets love that.

An uncertain election outcome

One last point: people are yakking about a possible uncertain election outcome after November 3rd. We won’t have an uncertain outcome. Guaranteed. We may have a slightly delayed outcome, which is different - like with the infamous year 2000 “hanging chad” court case.

If the election outcome is close, there will be court challenges and recount demands. That takes some time. Mail-in votes take longer to count--also delaying final results. Even so, it’s still a matter of weeks to certainty.

That this possibility is so widely bandied returns me back to my earlier point: markets pre-price all widely known facts and opinions.

The opinion that the election result may be delayed is something the market will intuitively pre-price.

Ken Fisher is founder and executive chairman of Fisher Investments. Follow him on Twitter @KennethLFisher.

Investing in securities involves a risk of loss. Past performance is never a guarantee of future returns. The foregoing is for general informational purposes and should not be regarded as personalized investment advice. Nothing herein is intended to be a recommendation or a forecast of market conditions. Rather it is intended to illustrate a point. Current and future markets may differ significantly from those illustrated here. Not all past forecasts were, nor future forecasts may be, as accurate as those predicted herein.