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Friday, November 21, 2003

Why investors should learn to stop worrying and love the Democrats 

Prof Hal Varian wrote a very interesting article in the NYT yesterday which investigates whether the stock market does better under the Democrats or the Republicans. Funnily enough, the Democrats win this one by a mile. Counter intuitive indeed. Prof Varian tries to explain using material from "Political Cycles and the Stock Market," authored by Pedro Santa-Clara and Rossen Valkanov.

Professors Santa-Clara and Valkanov look at the excess market return - the difference between a broad index of stock prices (similar to the Standard & Poor's 500-stock index) and the three-month Treasury bill rate - between 1927 and 1998. The excess return measures how attractive stock investments are compared with completely safe investments like short-term T-bills. Using this measure, they find that during those 72 years the stock market returned about 11 percent more a year under Democratic presidents and 2 percent more under Republicans - a striking difference.

What would cause such a large difference? One possibility is that Wall Street investors expect the Democrats to be bad for the market and sell their stocks before elections that the Democratic candidate is likely to win. Then, when the Democrats do not prove as bad as expected, stock prices rise again. The authors, though, find that the data do not support this theory - stock prices generally do not tend to decline before elections that Democrats win.

But this finding itself raises another puzzle. If returns are so much higher for Democratic presidents than Republican ones, shouldn't we see investors rushing to the market when a Democratic victory looks likely? We don't see that happen, either. "In sum,'' the authors write, "the market seems to react very little, if at all, to presidential election news." Here's another theory. Economic policies under Democratic administrations may tend to be more volatile than those under Republicans - so investors demand higher returns to compensate them for the extra risk. A clever idea, but it is also contradicted by the evidence. If anything, the volatility of stock market returns is slightly higher under Republicans than under Democrats.

Most provocatively, they suggest that the causality might go the other way, with market returns driving presidential elections. Perhaps voters feel wealthier when stock prices are high and then vote Republican; when stock prices are low, they vote for Democrats. The Santa-Clara/Valkanov finding offers an attractive area of research for both economists and political scientists. But even if scholars eventually come up with a satisfying explanation, we are still left with the financial side of the puzzle: For at least 72 years, the stock market did far better under Democratic presidents than under Republicans. How can it be that investors have failed to take advantage of this seemingly predictable pattern?