Market reactions to election outcomes: correlation or causation?

“I'm very familiar with how people can confuse correlation with causation.”

―Tim Ferriss

What does that mean in layman’s terms? Well, suppose one of your children is playing in a baseball game. You cheer yourself hoarse when she comes to the plate, and sure enough, she smacks a home run. Did you make that happen? In a word, no; there may be correlation, but there is no causation.

In investment circles, it’s hard to say which is more commonly debated: who will win the U.S. election, or which, if either, of the two candidates— former president Donald Trump or Vice President Kamala Harris—will have the greater impact on markets.

The challenge lies not only in predicting which campaign promises will turn into policy, but also in determining the form they’ll take. Commitments made in the heat of a presidential campaign often get sidetracked or reshaped by geopolitics, economic realities, or an unsympathetic Congress.

During the 2020 campaign, Joe Biden vowed that if he won, he would sign an executive order focusing on five ambitious climate goals. And yet, while Biden’s administration has successfully advanced several clean energy initiatives, the United States now produces more crude oil (13.2 million barrels per day) than it did in 2020, while the S&P 500 energy sector posted returns of nearly 42% during Biden’s four years in the White House.

Now, putting policy and personalities aside, let’s examine the impact—coincidental or otherwise—of a presidential election on U.S. stocks. 

Gauging the historical impact of a presidential election on U.S. stocks

We examined the calendar year returns (including dividends) for the S&P 500 Index going back to the Second World War. From 1945 to 2023, there has been a clear stock market favourite at the political party level. The S&P 500 Total Return Index averaged gains of more than 14% in years where the sitting president was a Democrat and more than 10% when a Republican was in office. The average return for all years during this time period was more than 12%, but averages don't provide the full picture. Notably, six of the worst calendar-year returns occurred during Republican administrations. While these outcomes could be attributed to specific policies, they were likely influenced by the broader fundamental environment and may have been coincidental rather than causal. For instance, during President Bill Clinton's two terms, the S&P 500 Index averaged 18.1% per year. The U.S. economy was thriving, and also benefited from structural dynamics driven by the consumption patterns of baby boomers. Similarly, President Barack Obama's first term began during the Great Financial Crisis, when markets had nowhere to go but up. That’s what they did, producing average returns of nearly 15% over the next eight years.

Historically, investors also tend to be less enthusiastic in election years. The S&P 500 Index posted an average return of just over 10% (including dividends) in years when Americans went to the polls. The fourth year of a president’s first term tends to be one of the best, returning an average of 14.68%. 

The stronger-than-average stock market performance data in the final year of a first term may have something to do with why a sitting president is often reelected. On only three occasions since 1945 (excluding Lyndon B. Johnson and Gerald Ford) has a president not won a second term.

In the first year of a president’s term, equity markets seem to favour the incumbent political party over a change in the White House. If the governing party retained power, the first year of the new term returned an average of 15.44%.  When there was a change in party, the first-year average return for the S&P 500 Index dropped to 5.71%. However, when looking at the full four-year term, the returns were virtually the same regardless of political party: 12.99% and 12.63%, respectively. This would suggest that the first year of a party change tends to be the worst year of the four. Regardless of the party in power, the third year is usually the best, with an average return of 22.59%. 

Looking ahead

Discussion about various political scenarios can be engaging, but predicting market performance based on these scenarios is pure speculation. Debate also persists about the extent to which politics actually influence market performance. The person most likely to influence returns in the near term may not be Donald Trump or Kamala Harris, but rather U.S. Federal Reserve (Fed) Chair Jerome Powell. The trajectory and extent of interest-rate adjustments by the Fed, along with their impact on the U.S. economy and inflation, are likely to have more of an effect on investment returns than the person who ultimately occupies the Oval Office. As voters prepare to cast their ballots, investors would be wise to concentrate on investment fundamentals rather than potential coincidences.