Despite the conventional belief that Republican politicians’ inclination towards lower taxes and reduced regulation would result in corporate profitability and stock market triumph, empirical evidence suggests otherwise.
Surprisingly, stock markets have historically delivered superior returns under Democratic presidencies compared to Republican ones, a phenomenon known as the “presidential puzzle.” This counterintuitive observation holds true over multiple decades and extends to the market as a whole.
Presidential impact
Research from the University of Notre Dame explores how presidential politics impacts the performance of individual stocks, and especially those that might benefit (or not) from any policies introduced by the president.
Companies’ alignment with a president’s policy agenda initially boosts their stock prices, but the effect is short-lived. Investors tend to overvalue policy alignment, pushing prices higher than actual value. Over a one-year period, companies not aligned with presidential policies deliver better returns.
To measure stock performance, researchers created the Presidential Economic Approval Rating Index (PEAR), tracking public approval of the president’s handling of the economy. They also introduced PEAR beta, measuring stock volatility relative to the president’s economic approval rating. Renewable Energy Group (biodiesel) and New Concept Energy (oil and gas) serve as an example during a transitional energy period.
Political support
“During the presidency of Barack Obama, the stock price of the clean energy firm outperformed the market, while the oil and gas firm did not. This is because when Obama’s policies were popular, there was a perception this will benefit clean energy firms. And that new regulations could hurt more heavily polluting traditional energy firms,” the researchers explain.
During the Obama administration, Renewable Energy Group enjoyed a significant PEAR beta premium, indicating a strong alignment with the president’s economic approval rating. However, contrary to expectations, the company achieved lower returns compared to New Concept Energy.
“This was caused by mispricing on the part of investors. When investors feel firms will do well, they price their stock too high. But when earnings are announced, they have made less money than they expected. They trade out of the stock and its price goes down,” the authors explain.
“We found analysts are too optimistic about high PEAR beta firms. Sometimes people get too excited, and there are not enough rational investors in the market to correct the overpricing. Investors need to face the reality of an earnings report before they admit their mistake. Eventually, they face reality and revise their expectations, but it takes up to a year.”
Investor sentiment
The relationship between the presidency and investor sentiment is evident in the convergence of PEAR betas for two energy stocks following Donald Trump’s election in 2016. However, their PEAR betas eventually diverged again, and New Concept Energy’s stock price rose due to its perceived alignment with the Trump administration’s support for fossil fuels.
This pattern extends beyond the energy sector, as observed in a comprehensive analysis of monthly stock returns using data from the Center for Research in Security Prices. On average, stocks with a low PEAR beta premium achieved 1 percent higher monthly returns.
These findings also apply to major economies closely tied to the United States, such as Canada, Germany, Japan, and the United Kingdom. Da suggests that these results highlight a market inefficiency that can be leveraged by savvy portfolio managers.
“Taking a practical point of view, we can identify a group of stocks with less risk, that outperform and have higher returns,” the authors conclude.
“You are systematically taking advantage of money left on the table by investors whose decisions are mostly driven by politics. They are essentially leaving money on the table, and you could pick it up.”
