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).

Although I’ve previously touched on the predictive quality of the IPO market, I wanted to bring it up again because what last year was a slow trickle has now dried up to an outright drought.

So far in the first quarter of 2008 we’ve had only 12 IPOs: 5 in January, 4 in February and 3 in March. The last one being the high profile initial public offering of Visa (V). It added an enormous $18 billion to the quarterly value number, leaving less than a billion for the other 11 IPOs.

Visa has also provided the best IPO performance this year with a 50% rise from its $44/share offer price. BioHeat (BHRT) has been the worst performer, with a return of -24%.

Although this lack of activity can be interpreted by some as being negative because it means less business for Wall Street, less money for companies that are growing, and less opportunity for investors to fund new enterprises, in actuality it is a sign of good things to come.

To understand why, we’d have to put on our contrarian goggles: a drought of IPOs mean that there is a total lack of ‘froth’ in the market; it means that VC’s are holding off selling their equity because they know that it won’t get a bid; it means that most investors are in a retrenchment mode and are in no mood to put new money in unproven companies, instead preferring to hold more conservative securities.

When you restrict the supply of something, demand being equal or growing, prices go up. Economics 101. So as public companies continue to buy up their shares and private ones refuse to go public, the ‘float’ of equity decreases… pushing up average aggregate share prices.

Also, historically periods of IPO drought have not meant that new companies do not grow or find funding. Instead they have denoted incredibly opportune times to invest in the stock market.

As the maxim goes, “Be bold when others are fearful and fearful when others are bold.” And right now it doesn’t take a genius to see that with a lack of IPO filings, nervous companies pulling their filings and an empty roster of secondary offerings… that fear is rampant on Wall Street.

I remember learning the predictive power of IPO trends during the height of the bubble. It was one of the most powerful arguments that convinced me we were indeed in a bubble and would soon see a bear market correction.

But right now its message is the opposite. Just as it was in early 2003.

Here are some IPO resources:

• Hoovers IPO Central
• Marketwatch IPO Overview
• CNN Money IPO
• Yahoo! Finance IPOs
• MSN Money IPO Center
• IPO Home by Renaissance Capital the managers of the IPO Mutual Fund

In this weekend’s Barron’s there was an interesting mention of research from Thomson Financial on the predictive abilities of the IPO market. They looked at whether an IPO trades above or below its price range and what bearing that has on the market going forward. Here’s an excerpt:

“THE BROAD MARKET IS WAY OFF its new highs, but according to one sentiment indicator of investor interest in initial public offerings, it still has plenty of room to run.

Thomson Financial calculated the ratio of IPOs that came out above the range of their expected offering price to those below the range on a quarterly basis going back to 1988, and found that periods where below-range prices dominated (ratios below one) were followed by above-average stock market returns in the next 12 months. The results are similar for shorter periods of three and six months.”

The bad news is that the second quarter of this year had an IPO market just slightly above the range, but the good news is that for all the four consecutive quarters before it was below. And for the month of July we are set to come in below again as well (at 0.7).

According to Steve Krull from Thomson Financial, this presents us with “a moderately bullish stance” where the S&P 500 is expected to end the year at 1700. As they mention in the article, this is just a tiny bit of an indicator and not something to trade on necessarily. But interesting nonetheless to tuck under your hat.