With 2016's contentious US presidential election just days away now, traders are still trying to game the outcome of this tightening race. With a Hillary Clinton victory long priced in, the mounting odds Donald Trump will prevail have big implications for major markets. One critical place traders should look for clues to how Americans will vote is the stock markets. Recent stock performance really sways election results.
This assertion certainly sounds dubious. When Americans are asked what the most-important issues for determining their votes are, the stock markets wouldn't even make the list. But interestingly a recent Pew Research poll found that the economy was the number-one issue in this election. 90% of Trump supporters, 80% of Clinton supporters, and 84% of all registered voters rated the economy at the very top.
That beat out terrorism as very important to 80% of all voters, foreign policy at 75%, health care at 74%, gun policy at 72%, and immigration at 70%. Nothing is more important to Americans than the economy. The state of it greatly affects our abilities to earn healthy incomes to support our families, our states of well-being, and our hopes for higher standards of living in the future. Americans have long voted with their wallets.
Naturally our perceptions of the state of the economy are heavily colored by our own experiences. If we are thriving and earning a good living, we tend to believe the overall US economy is strong because our personal economy is strong. But if we are struggling to make ends meet, our own financial challenges taint our perceptions of the general US economy. We extrapolate our own fortunes to a universal scale.
While professional traders have to follow major US economic data since it moves markets, it tends to be pretty technical and difficult for laymen to understand. It's surprising how often headline economic data like jobs or gross domestic product implies one thing, but those very same reports' internals suggest the exact opposite. An excellent example was last Friday's highly-anticipated initial number on US Q3 GDP.
The headline read of +2.9% annualized growth easily beat the +2.5% expected, so the media trumpeted accelerating strength in the US economy. Yet the internals of that same report were very weak. Consumer spending, which accounts for over 2/3rds of all US economic activity, was cut in half from +4.3% in Q2 to just +2.1% in Q3. Fully 0.83% of that 2.9% GDP growth came from an anomalous surge in US soybean exports!
How can busy Americans just trying to live their lives expect to wade through these endless torrential data streams? The US economy is fantastically complex and interrelated with everything, and thus very challenging for anyone to understand. So Americans naturally look for a simple proxy to represent how the overall economy is faring. And not surprisingly that happens to be prevailing US stock-market levels.
To the great majority of Americans, the stock markets are the economy! Every evening the mainstream media reports briefly on whether the stock markets were up or down that day. When they have rallied, the media looks for good economic news to attribute it to like a headline-GDP beat. When stock markets sell off, any weak economic news du jour is blamed. Stock-market fortunes greatly influence economic perceptions.
Experienced traders know this gross oversimplification is misleading. Collective greed and fear moves stock markets, forcing them to overvalued or undervalued levels relative to the underlying economy. But whether using stock markets as a US-economy proxy is righteous or not is irrelevant, since perception becomes reality in people's minds. This phenomenon makes stock markets really sway presidential elections.
The battle lines among the American electorate have long been drawn. About 40% of American voters will vote Republican no matter what, while a proportional opposing 40% will always vote Democrat. That leaves the remaining 20% of independents or swing voters to nearly always decide elections. And their collective opinions on who to support change based on their views of the US economy, and thus stock markets.
Unlike the hardcore bases of the two major political parties who knew they were going to vote for their own party's candidate forever, independent voters often don't make up their minds until the final weeks of a presidential race. As they tend to vote with their wallets, that makes their choices very susceptible to their latest perceptions of the US economy. And those are utterly dominated by recent stock-market fortunes.
There's been much research on this fascinating phenomenon of stock-market action leading into US presidential elections helping decide them, with various methodologies used. But most I've seen are limited in scope, like only looking at the post-World-War-II period. So this week as politics dominate our collective mindshare, I decided to finally do my own deeper study on stock markets and presidential elections.
While the flagship broad-market S&P 500 is a vastly-superior stock index on every front, the venerable Dow Jones Industrial Average is probably way more important for elections. Since the mainstream media is still always reporting on stock markets in Dow terms, that's the number most Americans follow. On top of that, the Dow's history stretches all the way back to 1885 compared to just 1957 for the S&P 500.
So the DJIA, or Dow 30, has continuity running all the way back to the 1888 US presidential election! That grants us the greatest-possible sample size for investigating the apparent impact on voters' choices from leading-in stock-market performance. Remember that US presidential elections are always held on the Tuesday immediately after the first Monday in November. That fixes the range at November 2nd to 8th.
I looked at leading-in stock-market performance per the Dow 30 in three separate ways. The first is how the Dow fared in the August, September, and October span leading into the early-November elections, or the final 3 calendar months. Next I cut out August and just considered the September-October span, the final 2 calendar months. Finally I looked at the precise 3 trading months running right up to election days.
The fascinating results are summarized in these tables. The first column shows the election year of the 32 US presidential elections since 1888. That's our sample size. The next five columns show how each election played out. The incumbent political party controlling the presidency leading into each election is listed, followed by which party actually won. Next comes the election result for the incumbent party.
Then the winning president is listed color-coded for his party, along with the percentage of the electoral-college votes he received. The United States of America is thankfully a Constitutional representative republic ruled by laws, not a democracy where majority mob-rule reigns. When I started this research, I was wondering if bigger leading-in stock-market moves resulted in larger electoral-vote wins by presidents.
The last six columns show the various market performances in Dow terms for August, September, and October (ASO), September and October (SO), and the precise final 3 trading months leading right into election days (F3m). The rule is simple. If the stock markets rose in a given span and the incumbent party won the presidency, or stock markets fell and the incumbent party lost, then the rule worked in that election.
That's the core crux of this thesis that leading-in stock-market action really sways presidential elections. If stock markets rally as independent voters are deciding how to cast their votes in the final pre-election weeks, then they feel better about the economy. So they vote for the incumbent party to maintain the status quo. If the economy seems to be improving as evidenced by stock markets, why change anything?
Conversely if the stock markets fall leading into elections these swing voters feel worse about the state of the economy. They fear their own personal economies will mirror that perceived downturn. Thus they decide to vote for a change of direction by supporting the challenging party's bid for the presidency. So the incumbent party is kicked out of office. The hard data shows stocks do really sway US presidential elections!
Given the long 131-year history of the Dow Jones Industrial Average, these 32 US presidential elections since 1888 are the largest-possible sample size. And the results are very compelling. The incumbent party wins the US presidency when stock markets are up leading into elections, and loses it when stocks are down, the great majority of the time. The probabilities vary slightly by rule, but are all quite high.
If the Dow 30 rises in that calendar August, September, and October span leading into early-November elections, or falls, the incumbent party indeed appropriately wins or loses the presidency fully 75% of the time! Using the September-October span, that dips modestly to a 69% chance of success for this rule. And avoiding calendar months for the precise final 3 trading months leading into election days, 75% success is again seen.
This is extraordinary, amazing, and maybe even disturbing. Out of the entire history of major US stock indexes, their performances in the final months leading into elections effectively predict the results a whopping 3/4ths of the times! All that campaigning, the billions of dollars now spent, the endless media coverage and stress presidential campaigns fuel, might all be for naught. The stock markets apparently trump all!
While the party faithful do their thing, the independent voters in the middle who determine the results are voting with their wallets. Their perceptions of US economic strength are positive when stock markets are rising, so they vote for more of the same through the incumbent party. But when stock markets fall leading into elections, they start to worry about their own economic fortunes and vote to kick out the incumbents.
This is disturbing because it is ripe for manipulation. Modern successful presidential campaigns cost well over a billion dollars to run. If an exceptionally-shrewd hedge-fund manager was given that kind of money to explicitly manipulate stock indexes, it might be possible to pull off. By strategically buying or selling highly-leveraged S&P 500 index futures at key technical breakpoints, stock markets might be herded.
So could a future presidential campaign try to briefly push stock markets higher if it held the presidency as the incumbent party, or short them lower if it was the challenger party? Maybe. A billion dollars isn't much money in stock-market terms, and wouldn't move stock markets for long. But with exquisite timing of futures trades and their outsized impact, and a bit of luck in the economic-news cycle, it could move the needle.
Interestingly it does look like the magnitude of stock-market move indeed affects the size of presidential wins in electoral-vote terms. The two biggest electoral-vote victories in modern times were Bill Clinton's 70% for his second term in 1996 and Barack Obama's 68% for his first term in 2008. Bill Clinton was the incumbent, and the stock markets rocketed higher in the final months leading into that 1996 election.
Conversely in 2008 Barack Obama was the challenger, and highly controversial due to his socialist and even Marxist policy positions. But he won a decisive victory against John McCain largely because stock markets plummeted in their first full-on panic in a century leading into that election! The American voters were understandably terrified of the US economy spiraling into a depression, so they booted the incumbent party.
And if political historians looked into the times the leading-in stock-market fortunes failed to sway if not predict the presidential-election outcomes, many would have exceptional circumstances. In 1956 for example, the stock markets plunged heading into early November. Yet popular general and war hero Dwight Eisenhower obliterated Adlai Stevenson, a former Illinois governor who had no real political base.
And a bit later in 1968, Richard Nixon beat the stock-market-forecast odds to win a narrow victory over Hubert Humphrey. He was the sitting vice president under Lyndon Johnson, who was wildly unpopular over his Vietnam war and extensive race riots. Still, challenger Nixon only won in a year stock markets soared heading into that election because third-party candidate George Wallace bled away 8.6% of the electoral vote!
All this history is fascinating, but the real question today is what are the stock markets implying about the outcome of this Tuesday's battle between Donald Trump and Hillary Clinton? Trump is the challenger since the Democratic party is incumbent with Obama currently holding the presidency. History has shown Hillary Clinton has a 3/4ths chance of winning if stock markets rally in the final months leading in.
Unfortunately for the Democrats, that didn't happen. The venerable Dow 30 actually fell a considerable and material 1.6% between the final trading days of July and October, and dropped a similar 1.4% in this year's calendar September and October. And though the stock markets' performance in the precise final 3 months leading into election day are not yet known, the Dow was way up at 18544 back at that start point.
As of this Wednesday, the data cutoff for this essay, the Dow 30 had fallen a major 3.1% since its close on August 5th exactly 3 months before election day. It's hard to imagine such a big loss being made up in the final few trading days heading into the election, no matter what happened in this morning's US monthly jobs report. The stock markets overwhelmingly and conclusively predict Donald Trump will win!
People like to argue that this election cycle is exceptionally wild, strange, and contentious. That may be true, but I'm skeptical. In doing the research for this essay, I studied every historical election where the stock-market rule failed. It is amazing how much social tumult there was, with serious issues ranging from wars to stock panics to depressions to political assassinations to racial unrest. 2016 feels tame in comparison.
While there has certainly been minor racial tension, this year has thankfully seen no wars, stock panics, depressions, or political assassinations. So odds are that 3/4ths historical chance that leading-in stock-market fortunes will sway this election's outcome will hold true. The caveat is we're only coming off all-time record stock-market highs. So maybe independents will feel like the US economy is thriving, and vote incumbent.
For weeks if not months, the financial markets have been overwhelmingly pricing in a Hillary Clinton victory on Tuesday. Polls have shown her with a commanding advantage, even though many of them are highly suspect for oversampling Democrats. Almost all the polls I've dug into survey Democrats on the order of 44% compared to 37% for Republicans, giving Clinton an automatic built-in lead of 7 points.
If she indeed wins as traders seem to expect, the markets aren't likely to change much since they are already positioned for that. But if Donald Trump surprises and beats the perceived long odds to win, the markets are in for some serious repositioning trading. Provocatively we don't even have to guess at what's likely to happen, as a preview conveniently played out last Friday on some major poll-swinging news.
Around 1:30pm on Friday October 28th, the FBI director shocked the world by writing a letter to Congress saying the FBI found new Hillary Clinton e-mails it needs to examine for classified information. This was a huge surprise because this same FBI director had all but exonerated Clinton in that same investigation just a few months earlier. Traders were suddenly faced with surging odds of Trump actually winning!
So what happened? The lofty overvalued stock markets sold off instantly and sharply. While Trump's lower taxes and less regulation should be very bullish for stocks over the long term, traders fear all the uncertainty a Trump Administration would bring. They think Clinton represents the Obama status quo, that nothing major will change. So a surprise Trump win Tuesday would likely unleash serious stock selling.
This can be gamed with put options in the flagship SPY SPDR S&P 500 ETF. If stock markets indeed drop on the uncertainty of a Trump win, or God forbid the far-worse uncertainty of a contested election, index puts are going to soar in value. Buying puts doesn't seem particularly risky, as stock markets are very high and overdue for a major selloff anyway. So a Clinton win is still very unlikely to spark a major rally.
The other major market move last Friday on the FBI reopening its investigations into Hillary Clinton was gold surging. Gold tends to move counter to stock markets, so as they dropped it immediately caught a big safe-haven bid. Gold has just green lighted a major new upleg after it got hammered back in early October as futures stops were run. So traders gaming a Trump victory can also go long gold and its miners' stocks.
The easiest way to get portfolio gold exposure is buying shares in or call options on the dominant GLD SPDR Gold Shares gold ETF. But gold's gains will be amplified as always by the stocks of its miners, as their profits really leverage gold upside. Gold stocks conveniently happen to be screaming buys right now for other reasons, and a Trump win can be played with their leading GDX VanEck Vectors Gold Miners ETF.
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The bottom line is stock-market fortunes in the final few months leading into US presidential elections really sway their results. If stock markets rally into early-November voting, the incumbent party is likely to win since voters feel comfortable about the state of the economy. But if stock markets fall in that critical sentiment-shaping span, independent voters start worrying about the economy and kick out the incumbent party.
For a century and a quarter, this simple stock-market rule has had a 3/4ths chance of predicting how a presidential election will play out. And this year the materially-weak stock markets since mid-August argue strongly in favor of the incumbent party losing. That means the odds of a Trump victory are much higher than traders believe, creating the potential for big market swings if he wins and traders rush to reposition.