The Stock Market And Elections: A Study In Correlation v. Causation
Brian Stoffel of The Motley Fool, who has a piece at Daily Finance (apparently an AOL site), seems to think he’s uncovered the key to predicting Presidential Elections:
This an election year, which means we are all faced with onslaught of political advertisements, prognostications, and endless poll numbers. Should candidates focus on values or the economy; foreign policy or domestic health care? Wading through all of it can be a difficult task for both candidates and voters.
But what if a look back at history showed that when it really comes down to brass tacks, there’s only one thing that determines the outcome of a presidential election?
The single metric that has been astonishingly accurate at predicting the outcome of presidential elections has been the movement of the Dow Jones Industrial Average (^DJI) from Sept. 1 to Election Day.
In support of this hypothesis, Stoffell notes the case that in 25 of the 28 Presidential elections that have taken place since 1900, the incumbent party has won, or held on to, the White House. (Stoffel lays forth the results for the Dow and the election results in the article and I’ll just assume he’s got the numbers for the Dow correct) That’s a pretty amazing accuracy rate of 89.3%, a rate that would make any pundit green with envy and one that a gambler would die for.
But what are we really looking at here? Even Stoffel admits that it’s unclear that what he’s pointing out is a predictor of election results, or merely a coincidence:
It’s entirely possible that the market — anticipating a change in power based on publicly available polling numbers — discounts equities on the market to reflect the uncertainty associated with the coming change.
A strong case could also be made for the role of independent swing voters and what’s called the “recency effect.” This describes the common phenomenon in which people ascribe a disproportionate weight to the newest information we’ve received: In essence, whatever has just happened plays a larger role in our decision making than what occurred further in the past.
Casual observers can see the recency effect in action every college football season, as the national rankings — which are determined by human votes — tend to favor teams that had their only loss early in the season as opposed to in the final games of the year. In much the same way, it could be argued, voters are willing to ignore the previous three years and 10 months of a president’s administration, and instead focus on his final two months.
It’s certainly the case that traders in Wall Street will be looking at the election and the polls as we get closer to Election Day. However, I’m not sure that it’s at all accurate to say that the up or down movement of the Dow is based on their interpretation of the election outcome alone. Certainly, that’s going to be something that they take into account but they’re going to be paying far more attention to the general condition of the economy, both nationally and internationally, along with data such as a interest rates, bond yields, and corporate profits. Similarly. I don’t think that many voters, especially those “independent swing voters” that Stoffel talks about, are going to be paying attention to the daily ups and downs of the Dow Jones Industrial Average. They’re going to be looking at their own economic situation, along with that of their neighbors, and possibly the “big” economic numbers that get attention in the media such as the Unemployment Rate.
To the extent that the movements in the Dow end up correlating so strongly with the results of Presidential elections it’s likely because the stock market reflects the overall health of the economy, not because it is some great predictor of political outcomes, or even that it has that much influence over how voters behave once they get to the voting booth. If the economy is doing well, the stock market will generally reflect that fact, and if the economy is doing well then the incumbent party is likely to do well on Election Day. If the economy isn’t doing well, then the stock market will reflect that, and the incumbent party will have a much rougher day on Election Day. What we’ve got here, then, is a correlation, but one that merely reflects the fact that both the stock market and the electoral hopes of an incumbent both tend to be tied to the economy. It’s not a predictor, and it’s unlikely that the stock market alone plays that big of a role in the outcome of an election.
One final thought occurs to me. I have to wonder why Stoffel chose to limit this study to the correlation between the DJIA and the election. Yes, the Dow is the best known of the stock market averages, but it is hardly the one that is most reflective of the market as a whole. It’s an index that includes only 30 stocks, as opposed to the 500 included in the S&P 500, or the 5,000 included in the Wilshire 5000. Why limit this study to only the narrowest index and not one of the broader ones? Is it possible that the predictive value of the other indexes isn’t nearly as good as the Blue Chips? It would be interesting to find out.