Timing the Market With the 2020 Presidential Election
Should investors consider the patterns that history suggests?
Investors familiar with the so-called presidential election cycle theory may be wondering if they’ll be able to accurately predict stock market performance in advance of November’s election. History suggests some patterns, but can they be used to improve investment results?
With the 2020 stock market already having hit record highs and several lows as a result of COVID-19, you may be wondering what to expect over the next few months. We take a look at the theory and what it means to investors as the election nears.
What Is Presidential Election Cycle Theory?
Presidential election cycle theory was first proposed in 1968 by Yale Hirsch, the author of the “Stock Trader’s Almanac.” The theory is that a newly elected president is initially focused on fulfilling campaign promises and political IOUs. These efforts have negatively affected the stock market, resulting in market bottoms within the first two years of a president’s four-year term.
In years three and four of their terms, incumbent presidents may be focused on re-election, the theory goes. They use all of the formidable tools and resources at their disposal to "pump" the economy. The financial markets typically respond by rising.
Presidential election cycle theory held some water in the 20th century but isn’t so predictive now. In the 21st century, the stock market has surged in the initial year of several presidencies. For example, the S&P 500 index rose in the first years of the Trump, Bush, and Obama administrations.
Consider these other historical hallmarks of presidential election cycle theory:
- Wars and recessions tend to occur during the first two years of a presidential term.
- Markets perform better when the incumbent party wins.
- August-to-October market performance may predict the presidential election. The incumbent party has retained power in 11 of 13 postwar elections when the market has been up from July 30 through October 31.
- The market has risen in the last seven months of a presidential election year in 15 of the 17 elections since 1952.
The theory also suggests that investors can "beat the market" by getting in toward the end of the first two years and getting out at the end of the election year.
Data seems to support this theory, too. According to a Fidelity study, over time, the first two years of a president's term are in fact generally associated with below-average returns, while years three and four are correlated with higher-than-average returns.
How Does This Affect Investors?
The observations of presidential election cycle theory and the supporting data don't translate into a reliable investment strategy, however. While returns in the first two years of a presidential term are typically below average, since 1984 they have been mostly positive.
In fact, overall, annual returns in years one and two of a presidential term have averaged 7.7% and 7.9%, respectively, since the first U.S. election in 1789. Staying out of the stock market consistently for two years would mean investing in CDs, Treasurys, or corporate bonds, which typically have lower returns.
President Trump’s Term Defies Pattern
Annual returns for the broad S&P 500 index during Trump’s term were much higher than average in years one and three, (up 19.42% and 28.88%, respectively), and much lower in year two with a 6.24% loss.
So far, stock market returns under the Trump administration have registered two “market bottoms.” These happened with a correction of 17.5% for the S&P 500 from a high of 2,929 points on Sept. 16, 2018, to 2,416 on December 16 of that year, and a plummet of about 34% in 2020 from 3,386 on February 19 to 2,237 on March 23.
Despite the dramatic drop earlier this year, the S&P 500 reached new highs in August and September, before dropping again. On Sept. 23, 2020—just about six weeks before Election Day and three months before the end of President Trump’s four-year term—the S&P 500 closed at 3,236.92.
At the end of a four-year term, history shows there is virtually no difference between the average annual returns for a Democratic or Republican presidency, registering average gains of 8.6% and 8.8%, respectively, according to the Fidelity study.
Market timing theories generally don't work in practice.
“Market timing doesn’t work for a whole host of reasons, but simply put—it requires investors to be right twice (when to get in and when to get out),” Ankur Patel, CFA, senior portfolio manager at Ellevest, told The Balance via email. “Research has shown that not only traditional retail investors have suffered from buying high and selling low.” Patel said that even the professionals can’t get it right consistently.
Tips for Investing in Presidential Election Years
Every day, every hour, there are predictions about who will win the election, why they will win, and what the markets will do. Some of them are bound to be right, but the question is, which ones? Former Federal Reserve Chairman Alan Greenspan predicted in 2007 that double-digit interest rates were on the horizon. Interest rates were at historic lows one year later. If Greenspan can get it wrong, so can everyone else.
The 2020 election most certainly will have an enormous impact on the country's direction. Still, markets have thrived before during difficult political times. The social and economic impact of COVID-19, racial justice protests, impeachment proceedings, a potentially contested election, and volatile markets have made 2020 challenging, to say the least. Yet the S&P 500 closed at an all-time high on Sept. 2 this year.
"One thing we do know is that markets go up over time,” Patel said. “Even if the elections may seem like a reason to reduce risk or make any kind of move, remember you can’t see the future with respect to the outcome of this election (especially this one), or the direction the market will take in the short term."
If you don't have an investment plan, now is a good time to establish one. Research shows that it doesn't matter when you get into the markets, as long as you stay invested over time.
- Presidential election cycle theory doesn't translate into a reliable investment strategy.
- The theory is proving less predictive for 21st-century presidential terms.
- The average annual returns of the S&P 500 after a four-year U.S. presidential term throughout history are roughly the same for Republicans and Democrats.
- Over time, markets have gone up, even through difficult environments.
- Don't let predictions about a presidential election and direction of the market derail your investment plan.