abstract
Capping Off the Elections
The Effect of Democratic and Republican Administrations
on Large-Cap and Small-Cap Stocks
There is considerable evidence that presidential elections influence stock and bond returns. Because Republican administrations have tended to be more “business friendly” than Democratic administrations, many observers assume that yields from stocks and bonds should trend higher when Republican presidents hold office. However, the evidence reveals a more subtle cause-and-effect. For instance, when Democrat Bill Clinton was president, S&P 500 stocks enjoyed an average annual return of 17% per year, a remarkable performance. However, during Republican George W. Bush’s tenure, the S&P 500 has been down annually by more than 2%.
What are the implications for investors now that voters have elected Barack Obama as the 44th president? Research by Hensel and Ziemba (1995) and Johnson, Chittenden, and Jensen (1999) reveals that investors should expect small-cap equities to yield higher returns than large-cap stocks, as the latter tend to do better during Republican administrations. The work of Grant and Trahan (2006) further suggests that corporate and US government notes and bonds are likely to do worse than if the Republican candidate, John McCain, had been elected instead.
The degree of influence that the presidential party really exerts on the returns across securities and portfolio compositions continues to be debated. But many of the voices in that debate are silent with regard to at least one other important influence on portfolio performance: the party in control of Congress. Investors would be wise to look at the party majorities in both the House of Representatives and the Senate when forecasting security market performance.
With Laffer and Petrino (1998)—and motivated by Laffer (1998)—I investigated this topic ten years ago, when we completed a study on the effects of Democratic and Republican administrations on both large-cap and small-cap stocks between 1926 and 1998. Kish and Thode (1999) have covered similar ground, with results that are supported by the research presented below.
The simple strategy of investing in small-cap stocks when Democrats are in the White House and large-cap stocks when Republicans are in charge is not likely to yield the highest rate of return.
Large-cap stocks should be the investment of
choice in all cases except when Democrats control both the presidency and Congress
or when a
Democrat holds the White House but neither
party dominates Congress.
This article’s findings derive from quarterly data supplied by Ibbotson Associates and running from the first quarter of 1926 through the third quarter of 2008. The large-cap stock total returns are based on the S&P 500 composite market value-weighted index with daily reinvestment of dividends. The small-cap stock total return series for 1982–2008 is the total return achieved by the DFA (Dimensional Fund Advisors) Small Company 9/10 Fund. That fund is a market-weighted index of the ninth and tenth deciles of the NYSE (New York Stock Exchange), plus stocks listed on the American Stock Exchange and over-the-counter market with capitalization equal to or less than the upper bound of the NYSE ninth decile. Prior to 1982, the series is represented by the historical series developed by Professor Rolf W. Banz and composed of stocks making up the ninth and tenth deciles of the NYSE.
A simple strategy of investing in small-cap stocks during Democratic administrations and investing in large-cap stocks during Republican administrations produces higher mean returns than if one were to have invested in a combination of the two in each case, or if one had invested in all large-cap or small-cap equities (which returned 10% and 12.1%, respectively), regardless of the party in the White House. That finding is supported by previous research, and illustrated in Table 1. In particular, Table 1 shows that the spread between small-cap and large-cap stocks during Democratic presidential administrations is 7.6% across 160 occurrences. During Republican administrations, however, the difference drops to -2.4% across 171 quarterly occurrences.
As revealing as this is, it cannot explain why large-cap stocks outperformed small-cap stocks during most of Clinton’s tenure as Democratic president, or why small-cap stocks have outperformed large-cap stocks since Bush took office in 2000. However, as shown in Table 2, during the periods when both the presidency and Congress (both the Senate and the House) were controlled by Democrats, small-cap stocks outperformed large-cap stocks by 11.3%, or 23.7% versus 12.4%. On the other hand, during the period when Congress was Republican and the president was a Democrat, large-cap stocks outperformed small-cap stocks by 6.7%, or 17.2% versus 10.5%.
During 1993–1994, when Clinton was president and both sections of Congress were controlled by Democrats, small-cap stocks outperformed large-cap stocks by 6.1%. However, during 1995–2000, once the balance of power in both the Senate and the House was in Republican hands, large-cap stocks outperformed small-cap stocks by 3.3%.
When both Congress and the presidency were under Republican control, large-cap stocks outperformed small-cap stocks by 7.8%. But when the Democrats took control of Congress, large-cap stocks outperformed small-caps by a margin of only 3%, or 7.9% versus 4.9%. And when neither party had majority control of both the House and Senate, small-cap equities outperformed by 4.2%. Moreover, in the original study of Broad et al., which included data through the second quarter of 1998, large-cap stocks outperformed small-cap stocks by 30 basis points under a Republican presidency and a mixed Congress.
All things considered, then, the simple strategy of investing in small-cap stocks when Democrats are in the White House and large-cap stocks when Republicans are in charge is not likely to yield the highest rate of return. To increase the probability of earning the highest return, Table 3 outlines a “combined” investment strategy. Succinctly, it shows that large-cap stocks should be the investment of choice in all cases except when Democrats control both the presidency and Congress or when a Democrat holds the White House but neither party dominates Congress.
Table 4 shows four investment strategies that were constructed from the above data to determine the approach that would have yielded the highest annual return from 1926 to 2008. The “combined strategy,” which relies on the investment approach laid out in Table 3, registers the greatest gain—14.1%. The second-place approach is the “president strategy,” in which investors concentrate on small-cap stocks when a Democrat controls the White House and large-cap stocks when a Republican controls it. However, the combined strategy beats out the president strategy by 60 basis points, or 14.1% to 13.5%. The combined strategy also significantly outperforms the returns of the large-cap and small-cap indexes, by 10% and 12.1%, respectively.
The standard deviation of the annual returns provides a metric of the risk inherent in each strategy. The most risk-averse investors should lean toward the “large-cap only” approach because it carries the least risk at the expense of a higher return. Interestingly, the combined strategy not only yields the highest return, but also has the second lowest risk, at 35.3%. The small-cap strategy registers the highest risk: 39.2%.
REFERENCES
Broad, Manuel B., Arthur B. Laffer, and Michael A. Petrino. 1998.“Democratic and Republican Administrations; Their Effect on Both Large- and Small-Cap Stocks—A 72-Year Study: 1926–1998.” Arthur Laffer Associates. 1–5.
Grant, James L. and Emery A. Trahan. 2006. “Tacit Asset Allocation and Presidential Elections.” Financial Services Review 15. 151–165.
Hensel, Chris R. and William T. Ziemba. March–April 1995. “United States Investment Returns during Democratic and Republican Administrations, 1928–1993.” Financial Analysts Journal. 61–69.
Johnson, Robert R., William Chittenden, and Gerald R. Jensen. 1999. “Presidential Politics, Stocks, Bonds, Bills, and Inflation.” Journal of Portfolio Management 26. 27–31.
Kish, Richard J. and Stephen F. Thode. 1999. “The Impact of Political Control on US Investment Returns, 1926–1999.” Journal of Investing 11. 43–46.
Laffer, Arthur B. August 5, 1998. “Do Good Gifts Come in Small Packages; or, Does Size Really Matter? Part 1.” Arthur Laffer Associates.
Manuel B. Broad, CFA, is a vice president in the wealth management division of the Bank of New York Mellon. He has been with BNY for over seven years, and has more than 15 years of experience with such firms as UBS, Prudential, and Calport Asset Management.
The views and opinions expressed herein are those of the author and do not necessarily reflect the views of the Bank of New York Mellon, its affiliates, or its employees.
