It's no surprise that a Presidential election affects the economy and markets. What is striking, however, is just how much the political cycle affects the business cycle. Ever since Harry S Truman trumped Thomas E. Dewey in 1948, the economy, the unemployment rate, and the stock market have done better on average in the year running up to the election, only to fall off the following year. The Standard & Poor's 500-stock index has averaged a 9.69% gain in an election year, and only a 4.01% increase the year after.
Of course, there are notable exceptions. In the year leading up to George H.W. Bush's 1988 defeat of Michael Dukakis, for example, the stock market rose 7.7%, and went on to gain almost 26% the next year. And investment managers warn against taking too simplistic an approach in trying to profit from a Presidential contest. "The election is part of a long list of variables that affects stocks," cautions Bob Doll, vice-chairman and chief investment officer of equities at BlackRock, the global investment and money-management firm.
One way investors try to play the election year in a focused way is through political portfolios Wall Street firms tend to roll out as the first Tuesday in November nears. These are simply lists of stocks in industries pundits think should become more profitable based on who becomes No. 44. For instance, the research firm International Strategy & Investment (ISI) is working on a John McCain equity portfolio and a Barack Obama portfolio, which should come out shortly.
The key to creating such portfolios is finding industries that would be most affected by clear policy differences between the candidates. For example, McCain is considered friendly to traditional energy and natural resource companies, such as those in coal and oil. The industry has contributed more than $4 million to Republicans this political season, according to the Center for Responsive Politics, compared with the $2.8 million the industry gave to Democrats. But if a Democrat wins the Presidency, with a Democratic Congress, "we've been telling investors we'll see more emphasis on clean energy, like wind and solar," says David M. Darst, chief investment strategist at Morgan Stanley's Global Wealth Management Group.
The investment banking industry is expected to fare better if McCain wins, since any new regulatory burdens are expected to be less onerous under a Republican Administration. The construction industry, however, could do better under Obama, given his emphasis on improving infrastructure.
The drug industry opens up another potential fault line between the candidates. McCain is seen as more likely than Obama to leave Big Pharma alone as President. With an Obama Administration, Darst would expect a greater focus on generic drugs.
A growing number of companies are signaling to investors that the political cycle matters to their bottom line. The Web site footnoted.org, which specializes in combing through regulatory filings companies provide to the Securities & Exchange Commission, notes that more health-care companies are emphasizing election-related risks. It cites a recent filing by insurer eHealth: "Certain candidates for the 2008 Presidential election have espoused...variations of a universal health-care system that would require a substantial number of individuals to purchase or otherwise obtain health insurance for themselves and/or their children. We cannot be certain of the impact of any new legislation...but it could harm our business, operating results, and financial condition."
Of course, a lot can happen between campaign stump speeches and the oath of office. In 1992, Bill Clinton ran on a platform that included heavy investment in infrastructure to shore up aging roads and bridges. Yet when he took office, it turned out he didn't have congressional support. The planned spending boom never happened. "We have a balance of power that doesn't let ideas that people think are too big happen," says OppenheimerFunds economist Brian Levitt.
Still, a cottage industry of academic research into Presidential portfolios supports the notion that you can make money investing in them. California Institute of Technology economist Andrea Mattozzi constructed a George W. Bush and an Al Gore portfolio for 2000. He built the portfolios by tapping into campaign contributions by publicly traded companies and identifying the major contributors to each side. He found that a change in the probability of a Bush victory as measured by the Iowa Electronic Markets, a Web-based futures exchange, was reflected in the portfolios. And for the six months before the election, the Bush portfolio returned 9.5% on an annualized basis, while the Gore portfolio lost 8.6%. (The S&P 500 fell 2.5%.) Yingmei Cheng, associate professor of finance at Florida State University College of Business, found a similar relationship with Bush and Kerry portfolios in 2004. (The portfolios had been created by ISI.)
Investing in stocks isn't the only way to play politics with your money. Among possible unfavorable outcomes for well-heeled investors in this election: higher taxes. McCain's tax-cut proposals are largely geared toward keeping taxes low for those with high incomes. Obama would raise taxes on the well-off and cut them for low- and middle-income taxpayers. High-tax-bracket investors could hedge against an Obama victory by buying municipal bonds. They currently offer a higher aftertax yield than comparable Treasuries, and that tax shelter will be more valuable if income tax rates go up.
One way to track how the election is going—and thus industries that may be most affected—is through political prediction markets. The most popular is the Iowa Electronic Market, operated by the University of Iowa's Henry B. Tippie College of Business. The futures contracts, which bet on the election outcome, trade on these markets just like corn or oil futures. It's not much of an investing strategy, though, since a portfolio position in the market is capped at $500. There isn't such a limit at Intrade, an Irish-based futures market. Trading volume at Intrade is running around $74 million, compared with $15 million in trading during the 2004 election. Still, that's tiny compared with the billions risked daily in oil futures contracts on the New York Mercantile Exchange.
There is good reason to monitor prediction markets: Academic research shows their record at foretelling election outcomes is better than that of polling data. On June 22 the Iowa market gave Obama a 62% probability of winning. At Intrade, it's 63.6%.
While the Iowa Electronic Market has been around just since 1998, betting on politics has a long history. There were well-organized Presidential betting pools between 1868 and 1940, according to Historical Presidential Betting Markets, a paper by economists Paul W. Rhode and Koleman S. Strumpf of the University of North Carolina, Chapel Hill.
In the late 19th and early 20th century, for example, betting on the Curb Exchange in New York (which evolved into the American Stock Exchange) and in the lobby of the New York Stock Exchange at times exceeded trading in stocks and bonds. In the New York markets, wagering on a Presidential election peaked with some $198 million (in 2008 dollars) in bets placed in 1916. That's when Democrat Woodrow Wilson came from behind to defeat Republican challenger Charles Evans Hughes. The amount gambled that year was twice the sum spent on the campaign. Rhode and Strumpf calculate that an average of $44 million, in 2008 dollars, was bet during Presidential contests from 1884 to 1928.
When it comes to wagering on who will win the race for the White House, odds are that the financial markets will anticipate the election better than the cable-TV pundits and pollsters. As the saying goes, history may not repeat itself, but it rhymes. Should old patterns hold, investors adept at reading political tea leaves may find election season not just great theater, but financially rewarding.