Trader’s Narrative

The prediction markets and the polls were correct. Barack Obama is the next president of the United States of America. As a quick aside, America please accept my hearty appreciation and congratulations for your choice. If you listened carefully, just before the thunderous celebration across the globe, you heard a sigh of relief.

Putting aside today’s market slide of 5%, the important question is what does Wall Street prefer? a Democrat or Republican in the White House? Republicans’ reputation is of being more capitalist and business friendly, and the Democrats of being “tax and spend” as well as more prone to regulation. But just like the myth of gold as a safe-haven, the facts do not support this assumption.

Here is a chart showing different historical returns for the stock market under different administrations (source: Federal Reserve Bank of San Francisco).

The biggest outliers in recent history are, of course, Coolidge who’s presidency oversaw the 1925-1929 bubble and Hoover, who presided over the bust that followed. But even if we ignore these or by extension of the time horizon, go back far enough, the relationship still holds: Democratic presidents coincide with much higher stock market returns.

Another study that looked at the relationship between politics and investment returns was by Pedro Santa-Clara and Rossen Valkanov. Their paper titled “The Presidential Puzzle: Political Cycles and the Stock Market” was published in The Journal of Finance in October 2003. In it they show that during Democratic governments, the US stock market (between 1927 - 1998) provides an excess return of 10.69% above the 3 month Treasury Bill rates. While Republican presidents provide an excess return of 1.69% over and above 3 month Treasury bill rates.

According to Ned Davis Research the S&P 500 Index performs poorest in the first year of the four-year election cycle. Since 1900, the stock market does best in the pre-election year (11.3%) and the election year itself (9.5%). The pre-election year didn’t live up to its historic pattern - to say the least!

Here is a recent visualization from the New York Times, showing 80 years of market returns:

Source: New York Times

If you aren’t satisfied with this myth being upended, here is an interesting tool that lets you make different assumptions about the stock market returns under different administrations. For example, you can check what would happen if we include dividend reinvestment. Or what about the effects of inflation? And time lag for policy effects? You get the idea.

President-Elect Barack Obama
In case you didn’t catch it, here is Obama’s victory speech (putting Cicero to shame).

Below is the chart for the brand-new market on whether Sarah Palin’s vice-presidential nomination will be withdrawn:

You can see the complete page at intrade here.

If you think that Palin will be John McCain’s running mate, then you would sell and pocket the difference as the market settles to zero. If you think that she will be replaced, then you would buy and pocket the difference when the market goes to $1.00

So right now this market’s conviction is that there is about a 15% chance for this event. To see what I mean, check out the chart of the market for Palin’s nomination:

As the chart shows, the nomination came out of left field but those who had bought made a lot of money!

Although many call these markets “prediction” markets, they aren’t crystal balls that perfectly foretell the future. They simply reflect all available information at a specific point in time. For example, check out what they were saying during the Democratic and Republican nomination process for president.

The Iowa Electronic Market is another well-known “prediction market”. You can see the graph of the presidential race here.