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Mythbusting: How Elections Affect Markets and ETFs

tlydon@globaltrend.com (Tom Lydon)

Elections do matter for the markets, but not necessarily for the reasons that investors tend to believe. Ahead of the US presidential election in November, I’m going to attempt to debunk some of the common myths surrounding markets and elections:

Myth #1: Party affiliation matters when it comes to market returns.

There is little to no evidence to support the fact that the winning candidate’s party makes a difference to markets. Over the past century, which party occupies the White House has had no discernible or consistent impact on US equity markets. Since 1900, when a Democrat has been in the White House, the average return for the Dow Jones Industrial Average has been around 8.5%; for Republicans the average is around 6% (neither average includes dividends). When you adjust those averages for the market’s volatility, the numbers are statistically the same.  In other words, the party affiliation of the president has had no consistent influence on stock market performance, though many investors still believe this.

Myth #2: Divided government is good for the financial markets.

Following the halcyon days of the 1990s, many investors have come to believe this myth. While divided government was certainly good for markets in the 1990s, that seems to have been an anomaly. The 1990s were unusual and were a function of many factors, including a secular drop in interest rates, a productivity surge, and the taming of inflation.  Unfortunately, conditions are very different today.

Looking at the last century of data, there is no evidence that divided government produces better returns. In fact, in the past equities appear to have actually done better when one party has controlled both Congress and the White House, though the numbers backing this better performance aren’t statistically significant and should be taken with more than a grain of salt.

What Does Matter: Policy

None of the above implies that the outcome of this election is irrelevant for financial markets. While politicians cannot fix much of what ails the global economy, sensible economic policy would help mitigate the damage. There is also quite a bit that politicians can do to make matters worse.  In short, as I write in my new Market Perspectives piece, the election will matter a great deal.

There are a number of issues, both long and short-term, which can only be solved in Washington. The absence of progress will likely worsen the economic malaise and in the case of the fiscal cliff push, the United States back into recession. On the other hand, real progress on taxes and entitlements could remove at least some of the headwinds holding back growth.

Both the fiscal cliff and the entitlements issue are extremely important to the capital markets. Evidence that we’re not doing everything we can to resolve them is likely to push stocks lower and volatility higher. To state the obvious, should we allow this to occur it would be a game changer for US financial markets.

If we wake up on the morning of November 7 with continued divided government and no consensus on reform and then no consensus is reached before the fiscal cliff hits in January, investors may want to consider opting for these five portfolio moves:

1.)  Less equity exposure

2.)  A higher allocation to defensive sectors like consumer staples and healthcare, accessible through the iShares S&P Global Consumer Staples Sector Index Fund (KXI) and the iShares S&P Global Healthcare Sector Index Fund (IXJ).

3.)  Less credit exposure in the fixed income section of their portfolios

4.) A smaller allocation to commodities

5.) A higher weight to dollar-denominated assets