With the Republican and Democratic national conventions coming up later this month, the 2016 presidential election is approaching the home stretch. Now that the Brexit vote is out of the way, the election is the largest near-term uncertainty for many traders.
Fortunately, presidential elections come around every four years. While there is uncertainty inherent in every election, traders have a long history of election-year data to analyze to predict stock market movement this election year.
Yale Hirsch is credited with the idea that U.S. presidential elections are tradable events. Hirsch compiled data on how the stock market performs throughout different years in a president’s term and found that stocks tend to perform better during the final two years than they do during the first two years. From 1948 to 2008, the S&P 500 averaged an 8.8% annual return during the first two years of U.S. presidents’ terms. In the second half of their terms, the returns nearly doubled to 16.0%.
In 2012, researchers at Pepperdine back-tested the election cycle theory by using historical market data from 1953 to 2012. The researchers found that by trading the Dow Jones Industrial Average based on the theory, traders would have generated staggering returns.
The Pepperdine researchers set up two hypothetical traders that started with $1,000. One trader invested in the Dow during the two favorable years of the election cycle and commercial paper rates during the two unfavorable years of the cycle. The other trader did the exact opposite and traded counter to the theory. The researchers found that the trader that traded in-line with the theory would have grown the $1,000 to $204,689 in less than 60 years. The trader trading counter to the theory would have grown the $1,000 to just $5,198.
Regardless of personal political beliefs, there is at least one piece of evidence suggesting that stock investors should be rooting for Hillary Clinton.
There’s an old Wall Street adage that suggests traders should “sell in May and go away.” However, during presidential election years since 1896, the Dow has generated an average gain of more than 4% from the beginning of May to the end of October.
But there’s a caveat to these strong pre-election returns: the incumbent party must win re-election. In election years in which the newly-elected president represents the same political party as the previous president, the Dow has produced an average gain of 7.4 percent in the six months leading up to the election. During election years in which the incumbent party ends up losing the election, the Dow has averaged a 1.1 percent loss in those same six months.
While numbers like these may seem to be the product of data mining, the correlation between the Dow’s May-October returns and the outcome of the election is statistically significant at a 95 percent confidence level. But as always, it’s important to remember that correlation doesn’t necessarily mean causation.
Traders and voters have a lot to think about in the next four months. The latest USA TODAY/Suffolk University Poll shows Clinton leading Donald Trump 45.6% to 40.4%.
If history is any indication, Clinton’s lead could be great news for the SPDR S&P 500 ETF Trust (NYSE: SPY) and the SPDR Dow Jones Industrial Average ETF (NYSE: DIA) in the next four months. However, according to the election cycle theory, regardless of which candidate becomes the next president, the market may have some tough years ahead in 2017 and 2018.
Disclosure: the author holds no position in the stocks mentioned.
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