Reaction of the US stock market to the political elections

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METHODOLOGY

Secondary data – the data in this research was obtained from journals, articles, research papers and economic letters written by scholars, economist specialists and analysts both from US and other parts of the world as well all featuring the reaction of stock market towards the US political elections.

Data was also obtained from CRSP US stock databases encompassing the data in monthly and quarterly basis. It includes historical indexes which serve as benchmarks for the investment community and as a foundation for this research paper. It contains index series that contains portfolios ranked in deciles.

STUDY AREA AND BACKGROUND INFORMATION

The study is to be carried by reviewing the secondary data sources such as data on economic letters, research papers, articles and journal with data collected by specialists, scholars and experts studying the United States Stock market and its returns. Notably, these analysts can be from US or other parts of America but must study the responsiveness of US markets to political elections.

STUDY DESIGN

This is political elections and stock market study making use of summarized descriptive statistics to determine the reaction of the US stock market to political reactions.

Moreover, the study has made use of hypothesis. Some of these hypotheses include:

H1: Available Information on election does not fully incorporate the stock prices.

H2: the results of the stock market do not show any democratic or republican premium.

H3: The generated abnormal returns and trading volume will be higher for some specific factors.

The research will also make use of new political models and also the use interview with Professor Alesina on the question, “what progress has been made in regard to the development of the new political macroeconomics?”

Additionally, we can gauge the reaction of stock market to political elections by gauging the reaction of stock market distribution to political elections using the volatility-event study approach.

SAMPLE SIZE

The study takes into use the reaction of stock market returns on quarterly basis in percentage from the year 1871 to 1997 and also from 2000 to 2012.

SUBJECT

The study features the responsiveness of the US stock market to various political elections and presidential heads.

CONTROL VARIABLES

The variables in this case are not control variables as they keep on changing.

ECONOMETRIC MODEL AND EQUATIONS

In the methodology chapter I will makes use of formulas, econometric models and equations in an attempt to calculate the relevant stock market returns as witnessed by different political elections. These equations will be of great importance once it comes to the analysis of data on stock returns as a result of different political wings. These formulas include calculation of returns using the formula:

Abnormal Returns= Actual Returns minus Expected Returns.

More of interest this formula will be used to calculate abnormal volume during the political election periods. Moreover, I will make use of the five factor model by Fama and French in the analysis of the stock market returns. This econometric model makes use of five factors (2×3) in its computation of market stock returns. These factors include company size, company price-to-book ratio, market risk, profitability and investment. Firstly, it is constructed using the 6 value-weight portfolios formed depending on size and book-to-book-market. Secondary, the 6 value-weight portfolios formed on size and operating profitability, and thirdly the 6 value-weight portfolios formed on size and investment. Particularly, the five-factor model improves the explanatory power of the returns of stocks. Therefore, to use the five factor model one has to take keen note on the following formulas and terms.

  • SMB (Small minus Big) is the average return on the nine small stock portfolios minus the average return on the nine big stock portfolios,

SMB (B/M) =     1/3 (Small Value + Small Neutral + Small Growth)

– 1/3 (Big Value + Big Neutral + Big Growth).

SMB (OP) =1/3 (Small Robust + Small Neutral + Small Weak)

– 1/3 (Big Robust + Big Neutral + Big Weak).

SMB (INV) = 1/3 (Small Conservative + Small Neutral + Small Aggressive)

– 1/3 (Big Conservative + Big Neutral + Big Aggressive).

SMB =1/3 (SMB(B/M) + SMB(OP) + SMB(INV) ).

  • HML (High minus Low) is the average return on the two value portfolios minus the average return on the two growth portfolios,

HML =1/2 (Small Value + Big Value)

– 1/2 (Small Growth + Big Growth).

  • RMW (Robust minus Weak) is the average return on the two robust operating profitability portfolios minus the average return on the two weak operating profitability portfolios,

RMW =1/2 (Small Robust + Big Robust)

– 1/2 (Small Weak + Big Weak).

  • CMA (Conservative Minus Aggressive) is the average return on the two conservative investment portfolios minus the average return on the two aggressive investment portfolios,

CMA =1/2 (Small Conservative + Big Conservative)

– 1/2 (Small Aggressive + Big Aggressive).

Rm-Rf, the excess return on the market, value-weight return of all CRSP firms incorporated in the US and listed on the NYSE, AMEX, or NASDAQ that have a CRSP share code of 10 or 11 at the beginning of month t, good shares and price data at the beginning of t, and good return data for t minus the one-month Treasury bill rate (from Ibbotson Associates).

Also, to test the impact or reaction of stock market as a result of political election can be assessed by use bootstrap methodology of Efron (1979). Similarly, taking into consideration the cumulative abnormal volatility during the election period and then comparing it with the empirical distribution of Cumulative Abnormal Volatility simulated under the null hypothesis could also work. Furthermore, the volatility of the stock market can be estimated by use of regression analysis. Besides, the plotting of a correlation graph could also help to establish the relationship between stock markets and political elections. If a graph of the political year is plotted against the stock market returns and the data scatters from lower left to upper right then we conclude that the two variables are positively correlated and the opposite is true.

DATA COLLECTION

The data below was collected from articles, journal and research papers written by different experts, political and business expertise as well as economists as it will be shown below in data provided in depth.

DATA COLLECTION TOOLS

The research study will use secondary data based on data collected by philosophers, business experts, and economists (the articles, journals and economic and research letters are analyzed).

STUDY VARIABLES

Independent variable

Political elections

Democratic or Republican presidents

Dependent Variable

The stock markets

The annual Stock Returns

INCLUSION CRITERIA

The stock market returns of the United States America as a result of political election whether within or outside the country.

EXCLUSION CRITERIA

The reaction of other countries’ stock market returns as a result of US political elections.

LIST OF DATA SOURCES

This chapter includes all key areas where the data being studied on the reaction of US stock market in relevance to the political elections can be obtained, found or collected from.  Most of the data in this research paper has been obtained from CRSP US stock databases. A few other research papers have been used to support the data from CRSP US stock database.

  1. The CRSP database provides the following set of data of the quarterly returns from the year 1871 to 1997 according to the stock returns registered under the leadership of the different presidents who have been in power since 1871.

Republican President

Grant 71 – 72

Grant 73 – 76

Hayes 77 –  80

Gar/Art 81 – 84

Harrison 89 – 92

McKinley 97 – 00

McKin/RT 01 – 04

Roosevelt 05 – 08

Taft 09-09 – 12

 

Quarterly Returns (%)

12

-3

23

-1

8

19

12

12

8

 

Republican President

Harding/Cool 21 – 24

Coolidge 25 – 28

Hoover 29 – 32

Eisenhower 53 -56

Eisenhower 57 -60

Nixon 69 – 72

Ford 73- 76

Reagan 81 – 84

Reagan 85 – 88

 

Annual Returns (%)

19

30

-22

24

12

8

5

11

20

 

Republican Presidents

BUSH 89 – 92

 

Return%

19

Table1. Shows the Average quarterly analysis of the stock market returns from 1871 – 1997 when the Republican Presidents were in power.

Graph1. Illustrates the quarterly stock market returns from 1871 – 1997 in percentage under the leadership of Republican Presidents.

Democratic Presidents

Cleveland 85-88

Cleveland 93-96

Wilson 13 – 16

Wilson 17 -20

Roosevelt 33-36

Roosevelt 37 -40

Roosevelt 41 -44

DR/Truman 45 -48

Truman 45 -48

 

Quarterly Stock Returns (%)

9

-3

8

1

34

-4

14

12

23

 

Democratic Presidents

JFK/LBJ 61 – 64

Johnson 65 -68

Carter 77 – 80

Clinton 93 -96

Clinton 97

 

Quarterly Stock Returns (%)

15

10

13

17

34

Table 1.0 shows the quarterly stock market returns for democratic presidents for the year 1871-1997 in percentage.(Extracted from FRBSF Economic Letter).

Graph 1.0 Illustrates the amount of stock market returns for democratic presidents as from 1871-1997.

  1. Also, according to Trevir Nath’s data as on March 1, 2016, data reveals that is a correlation on how the stock market behaves when a US president ascends to power after political elections. Notably, it is well known that the stock market has performed well under the Democratic candidatures. Particularly, The Dow Jones Industrial Average has shown that the average returns of the stock market when the US citizens elect a Democratic president is 82.7% as opposed to the 44.8% average returns which is realized under the election of a Republican leader.

iii. Moreover, according to the researches carried by Yale Hirsch, in his journal The Presidential Election Cycle, he exemplified that the stock markets tended to be strongest at the third year of presidency (Kräussl et al 2014). More data still argues not dictate that the first year that averagely, the S&P 500 realizes 17.5% gains in the third year of a president’s first term whereas in the second term it experiences a drastic drop down to 11.5% stock market returns. However this does not mean that year 3 is always the best. It is known that the stock market experiences some volatility in the first year after elections as the market is already trying to adapt to the new changes hence it reports minimal stock market returns. The returns gradually grow to its peak in the second year with the third year registering highest returns. In cases of run off of political elections the returns in the stock market tend to grow sideways as a lot of uncertainties arise. During the final year of an election cycle the average stock market returns fall to 6.1% during the last year of that elections term (http://www.nasdaq.com/article/how-presidential-elections-affect-the-stock-markets-cm586601#ixzz4i6D0wyss).

  1. Additionally, according to Presidential approval ratings in the end of each month provided by Gallup database and expressed in a quarterly basis argues that on regular basis, it is easy to try and figure out who is more likely to be elected as the president basing our argument on the 3 months returns of the S&P 500 preceding an election. Moreover, if the incumbent president records an increase in index between July and October, then his likelihood of being reelected is high. Also, data based on the president’s approval rating indicate that overally only five presidents in the history of America have registered an equity rise of more than 50% during their terms in office. Of particular importance they include the recent Barack Obama and Bill Clinton. On the other hand Richard Nixon recorded the greatest drop-off of stock market returns in the presidency history of US as it was characterized by Great Depression and the Watergate scandal.
  2. Besides, we also use data from the book, “The Stock, Bonds, Bills, and Inflation Yearbook, 1998, by Ibbotson Associates.” We rely on the annual data collected from 1926-1997 on performance of the stock markets when different political heads have been in power. To make the data more realistic and exemplified we also connect it with some essential stock index data from Cowles Commission presented in Wilson and Jones (1987). Notably, both of the serial documentaries represent a larger view index of total stock returns for a portfolio of large stocks. Therefore, in the year 1926-1956 the index of large stock market returns is S&P 90 whereas from 1957-1997 it records index returns of S&P 500. Particularly, the period between 1871 and 1925 Cowles index realized the largest stocks in US market, with a sum of 48 in 1870 and rapidly rose to 258 in 1925.
  3. Moreover, the findings from FRBSF economic letter coincide with another set of data as reported by Siegel 1994 for the DJIA. From his data the average returns witnessed in the year 1948 and 1992 was 13.4% under the political wing of democrats while the Republicans registered average stock returns of 11.4%. Siegel went further to conclude that the stock market fared well when a democrat leader was in power as compared to when the Republicans were in power. Similarly, that was the case in both nominal and real values. He uses data collected on quarterly basis since viewing it on a broader view reported that the returns are not statistically different.

vii. The new political macroeconomics – this sought of data provides the relationship between the political factors arising from a political election and macroeconomic concepts which are very vital in dealing with the stock market returns. It takes key note on the political factors that really affect the business cycles and during the process they end up interfering with the performance of US stock market. Beyond, they include factors such as conduct and implementation of stabilization policies, inflation, budget deficits among others.  (Alesina, 1987).

viii. In general data on the reaction of stock market to the political elections from was extracted from voters by rational investors by use of methods such as polls, electoral debate, and synthesis of macroeconomic data. Moreover, according to Dana Anaspach (2016) the stock markets have always had a strong positive correlation with the political elections in The United States of America. The elections have consequently reported more positive impacts to the stock markets as compared to the negative impacts. This idea of Anaspach is later expounded by Marshall D. Nickles in his article known as Presidential Elections and Stock Market Cycles. Furthermore, his data continues to argue that for an investor to realize good stock market returns the best time to invest is on October 1st during the second year of the presidential term and sell on December 31st of the four year and this would attract profitable outcomes. Other specialists who join hands with Marshall on the idea are Junkans, CFA, and their Senior Investment Manager, James P. Estes, PhD, CFP(1) they exemplify  that the average stock  market return in the fourth year of a presidential term is twice that of the return in the first year of a president’s term. The stock market returns of the last recent 17 years are shown below.

Table1.1 above Market Returns for the Recent Election Years Since 2000

Data Above is from Dimensional Funds Matrix Book.

  1. Stock market volatility around national elections, Jedrzej Bialkowski (2006). This research article gives the major factors that result to the volatility of the stock market as political elections approach. Moreover he tries to exemplify the key determinants of the volatility by constructing a comprehensive set of data variables. Consequently, these variables are meant to provide further insights into the political, institutional, and socio-economic factors which could influence the magnitude of election shocks. To be specific some of the key variables that are very essential include:
  • The number of parties indicates the number of independent political parties involved in the government coalition for parliamentary systems. More specifically, it pays keen attention to the price list of the presidential systems.
  • The parliamentary (dummy variable) – this variable takes into consideration the difference between parliamentary and presidential systems.
  • The margin of victory is defined as the difference between the percentage of popular votes obtained by government coalition and opposition for parliamentary elections, and the corresponding difference between winner and runner-up for presidential races.
  • Orientation (dummy variable) –it shows how responsive the political orientation of the government is.
  • Early Election (dummy variable)- of particular interest elections that are called more than three months before the official end of the tenure of the incumbent administration attracts early high returns in the market hence slow volatilization.
  • Compulsory Voting (dummy variable) – it demonstrates some of the countries that have mandatory voting laws to ensure every interest of each citizen is taken care of.

In summary, with emergence of well stabilized market forces and control over inflation, the rate of volatilization in stock markets can be overcome. With many specialists dealing timely with the major causal agents of volatility in the stock market returns (Bialkowski et al, 2008).