Trade the Election? History Shows It’s a Mug’s Game

Following a presidential election, the stock market usually renders a swift verdict on the winner. The trouble is, the market's decision is often overturned on appeal in the weeks and months to come.

Economic forces and unforeseen events soon take over, rendering those hasty bets based on the final Electoral College tally little better than a coin flip.

Over the past 14 presidential races, the stock market rallied on the Wednesday following Election Day six times and declined eight. In those six years when the market responded to the upside, stocks continued higher for the subsequent week every time, according to a study by www.SentimenTrader.com.

The other eight years, the market's negative response persisted over the following week six times, a pronounced record of weakness given stocks' general historical tendency to rise in any given week.

Predictions Often Fail

Yet beyond about two weeks from Election Day, subsequent returns bear no particular relationship to the market's initial move, mooting all efforts by financial handicappers to divine a causal link between the identity of the head of state and the prospects for stocks over the span of his term in office.

The financial markets are simply too complex, driven by too many inscrutable clues about future corporate growth and ambiguous forces behind global capital flows, to follow a schematic script based on the occupant of the White House.

Markets, for one thing, do their best to forecast and discount future events before they're entirely set. This means that calling the market response, based even on a known election result, also requires guessing to what degree stock and bond prices have already figured out the winner before the balloons and confetti have fallen in the victor's hotel ballroom.

Finally, if the chief executive of the country were a reliable and decisive factor in the strength of the market, then stocks would be expected to trend mostly in one direction over the course of a president's four-year term, which almost never happens.

This fact was demonstrated in extreme form the past presidential term. Stocks had been falling for a year from an all-time peak when voters chose President Obama in '08 as subprime mortgage losses had morphed into a pervasive banking crisis, recession and global asset liquidation. The market dropped another 20% by inauguration day, shuttled to a 13-year low in early March, then rebounded forcefully, more than doubling over the next three years despite suffering two declines of 15% or more along the way.

History is also not kind to those ubiquitous efforts by investment strategists (and financial reporters) to translate a candidate's known policy priorities and prescriptions into a selection of likely winning and losing stocks and sectors following an electoral victory.

A review of the crop of articles from four years ago suggesting stock portfolios that would benefit from a win by Barack Obama, or an upset by Sen. John McCain, revealed a broad consensus. Under Obama, it was commonly thought that financial stocks would suffer, alternative-energy shares would prosper, agricultural plays would rally on his ethanol support and the health care sector would be depressed by universal-medical-coverage proposals.

As it happened, financial stocks, already in free fall in November 2008 following the collapse of Lehman Brothers and the global market panic, are about flat since the day Obama was elected, compared to a 40% gain by the Standard & Poor's 500 index. Yet since he was inaugurated Jan. 20, 2009, the Financial Select Sector SPDR exchange-traded fund (XLF) has doubled, against a 75% rise in the benchmark index.

First Solar Inc. (FSLR) was repeatedly named as a worthy vehicle to profit from Obama's expected clean-energy initiatives. Yet the stock was already bloated by solar-panel hype as oil surged above $100 in 2007 and 2008. Since Nov. 4, 2008, First Solar is the single worst-performing stock in the S&P 500, according to Bespoke Investment Group, with an 86% loss.

Farming names such as Deere & Co. (DE) have outperformed the market nicely, but it has little if anything to do with an ethanol boom -- China's burgeoning hunger for more and better food is the bigger influence.

As for health care stocks, they have been among the leading groups as the market took to focusing on Obamacare's potential to enlarge the customer base for health insurance and prescriptions, rather than price controls. The Morgan Stanley Healthcare Payor index (^HMO) is up 160% under Obama.

The Market Knows Best

One of the more consistent election-related investing guides is simply the four-year election-year cycle, which itself suggests next year will start with a headwind against it (though this pattern, too, didn't help the past four years).

More systematic investing methods related to electoral outcomes have been shown to have some merit in academic analyses. Yingmei Cheng of Florida State University constructed stock baskets based on the companies that had donated the most to either the John Kerry or George W. Bush campaigns ahead of the 2004 election. He found that these contrasting portfolios closely tracked the rise and fall of the relevant candidate in political betting forums, and performed in line with Election Day returns.

Such an approach would likely favor big banks and defense contractors should Romney win, and media companies if Obama is re-elected.

Then again, by now the market probably has already valued the likely outcome before those playing at home had a chance to lay their bets.