Tuesday, November 02, 2004

Political Cycles & Stocks

Rossen Valkanov of the Anderson School of Management at UCLA has an interesting paper titled "Political Cycles And The Stock Market"(Journal of Finance 58, 1841-1872, October 2003)

The excess return in the stock market is higher under Democratic than Republican presidencies: nine percent for the value-weighted and 16 percent for the equal-weighted portfolio. The difference comes from higher real stock returns and lower real interest rates, is statistically significant, and is robust in subsamples. The difference in returns is not explained by business-cycle variables related to expected returns, and is not concentrated around election dates. There is no difference in the riskiness of the stock market across presidencies that could justify a risk premium. The difference in returns through the political cycle is therefore a puzzle.
Using data since 1927, we find that the average excess return of the value-weighted CRSP index over the three-month Treasury bill rate has been about two percent under Republican and 11 percent under Democratic presidents — a striking difference of nine percent per year! This difference is economically and statistically significant
A clear possibility is that our findings might be the product of data mining. Taking
into account that, over the years, researchers (and investors) have tried countless variables to forecast stock market returns, it might just be the case that we have stumbled upon a variable that tests significantly even when there is actually no underlying relation between the presidency and the stock market. As pointed out by many authors, and illustrated by Sullivan, Timmermann, and White (2001), if one correlates enough variables with market returns, some spurious relations are likely to be found.

An instability in the government is not liked by the markets. In the event of an ambiguous election, this might weaken markets. On the other hand, that could be exactly what the market needs to shake it out of its torpor and start moving again. This crisis could serve as a positive impetus.

Many authors have noted that crises provide significant buying opportunities in various markets. Traditionally, stocks and bonds have exhibited inverse behavior due to the bond yield curve. With the decision of the Treasury Department to stop sales of long term bonds in 2001, this principle may be in jeopardy, and it is likely that both stocks and bonds will do equally poorly over the short term. Marc Faber, Dr Doom, feels that

today monetary policies are ultra expansionary and inflationary since short-term rates are not only below the rate of nominal GDP growth (see figure 1) but also significantly below long term interest rates
We can, therefore, say that today, because of excessive debts in the system, debt growth and fiscal deficits are far less effective at stimulating the economy than they were at the time of President Reagan. In fact, I would argue that for monetary policies the “ Mother of all Monetary Tests ” is unfolding right now, as it may be that monetary stimulus is no longer going to boost the economy, but inflation alone, which would lead in a benign scenario to stagflation and in a worst case scenario to a inflationary depression a la 1980s in Latin America

yield spread

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