US elections entwined with stock market fortunes

Markets typically rally in the months following American midterm elections

Today is midterm elections day in the United States, with continued political gridlock – a Democratic president hobbled by Republican control of the Senate and the broader Congress – widely predicted.

Does it matter to investors? History says yes, with markets typically rallying in the months following midterm elections.

In fact, research shows that stock market performance and the wider political environment are inextricably intertwined, with a myriad of different studies revealing the close – often too close – relationship between politicians and business leaders.

Mid

term boost Many investors might assume the US mid

term elections to be of little importance to investors in the US and further afield, but money manager Robert Doll says they are "huge" for the market.

“It isn’t all about which political party wins,” Doll said last week. “What’s more important is to actually have the midterm elections and remove uncertainty from the financial markets.”

The removal of that uncertainty, he says, has resulted in the S&P 500 gaining in every six-month period following the last 16 midterm elections, with an average gain of 16 per cent.

Presidential cycle

One could also argue that the gains that typically follow midterm elections are not a collective sign of relief from investors; rather they may be related to the so-called presidential cycle.

Since 1900, the third year of a US presidency has been easily the best year for markets, with investors enjoying median annual gains of 16.5 per cent.

Returns during the first half of presidential terms are far less impressive, median returns falling to just 2.2 per cent in the second year of the cycle.

There is an obvious explanation for the wide divergence in returns – political manipulation, with presidents preferring to stimulate the economy as election date draws nearer.

Sceptics will note the S&P 500 has been anything but weak over the past two years, returning more than 30 per cent in 2013 and rising another 8 per cent this year.

Supporters of the indicator, however, say no signal is guaranteed to work on every occasion. In fact, a Goldman Sachs report last year recommended investors everywhere follow US political developments, saying America’s election cycle “helps to explain a sizable fraction of non-US equity returns, both in other developed markets and in emerging markets”.

Market predictions

If investors should keep a close eye on the political cycle, so too should politicians follow market developments. The stock market has correctly forecast 26 of the last 29 presidential elections, according to a report by US firm InvesTech Research. Since 1900, stock markets have risen in the two-month period leading up to election day on 17 occasions; the incumbent party was re-elected 16 of those 17 times. Stocks declined 12 times, with the incumbent losing on 10 of those occasions.

“Wall Street typically worries about how politics might affect the stock market,” noted InvesTech. “Perhaps presidential candidates should worry about how the stock market might affect their political outcome.”

Political contributions It pays to be generous towards politicians, according to a 2008 study that examined 819,000 contributions made by almost 2,000 US firms over a 25-year period.

Big donations are not necessary, according to the authors of Corporate Political Contributions and Stock Returns; rather, it's better to donate money to as many politicians as possible, in the hope a few will eventually return the favour in spades.

The best returns – annual outperformance of 6 per cent – accrued to companies following this model of financial promiscuity.

This was no coincidence, the authors finding “quite startling” evidence regarding the benefits of corporate donations.

The “contribution effect” was most evident among companies that supported the most powerful politicians; future profitability improved; corporate contributions decreased when particular politicians no longer had jurisdiction over company affairs.

Only about 10 per cent of firms are politically active, according to the study. Typically, donors performed poorly over the previous three years, indicating a “greater incentive” to establish political connections.

Overall, the rewards enjoyed by companies far outweigh the cost of donations to political parties, so why don’t more firms follow such a policy?

The true cost to companies may be greater, the authors suggest, and “potentially include other off-the- books contributions or non-money favours, for which only large firms can afford to pay”.

Politically connected firms Unsurprisingly, this phenomenon is not confined to the United States. Politically connected firms around the world are almost invariably more prosperous than their competitors, especially in more corrupt countries.

The health of Suharto, the dictator who ruled Indonesia from 1967 to 1998, became an increasing concern to many connected firms in the late 1990s.

In 1996, shares in Bimantara Citra, a media conglomerate connected to Suharto, fell 10 per cent in two days following the announcement that the president was to undergo a health check-up in Germany; as the Financial Times later put it, shares in the group tended to catch pneumonia whenever Suharto caught a cold.

A 2001 study confirmed politically connected firms suffered lower returns whenever media reports surfaced regarding Suharto’s health, with losses increasing during more severe health scares.

Another study which looked at government bailouts of troubled companies over the 1997-2002 period, found politically connected firms were “significantly more likely to be bailed out” than distressed non-connected firms.

Another paper, examining the share prices of more than 20,000 firms in 47 countries, noted share prices increased significantly when top executives or large shareholders entered politics. Yet another found share prices in companies decline when a politically connected legislator unexpectedly dies.

Cronyism is an age-old problem. Companies that lent support to the Nazis, one study found, outperformed by up to 8 per cent following Hitler’s ascent to power in early 1933. The bigger companies were far more likely to bet on Hitler, the study found – although just one in five firms was in any way connected to the Nazis, they accounted for more than half of the total market capitalisation of the Berlin market.

‘T

ight overlap’ Just as political elites clearly bestow favours on connected firms,

companies reward their political backers. In France, for example, there is a “tight overlap” between chief executives and politicians, according to a 2005 study: more than half of assets traded on French stock markets were managed by chief executives who were formerly civil servants, many holding government posts.

Firms managed by connected executives were more likely to create jobs in “politically more contested areas”, the study found, especially so around election years. These economic favours tend to be reciprocated, the grateful politicos later granting companies “privileged access to subsidy programmes”.

C

onfidential company information Rewarding loyal politicians with local jobs, as in the French example, is one way of showing your gratitude: another is to pass on confidential company information.

It’s hard to imagine the latter is uncommon in the US, given politicians’ formidable trading records. A 2004 study found stocks bought by senators “tended to stagnate prior to purchase, soar after purchase and then stagnate again after sale”, ensuring they beat the market by 10 percentage points a year.

A 2011 study by the same researchers examined congressmen’s trading. Over a 16-year period, they beat the market by more than 6 percentage points annually – not as impressive as the senators, but a performance of which most professional fund managers can only dream.