The "presidential puzzle" effect
Sergey Gurov
Aug 26, 2023On August 23, one of the first major events of the 2024 presidential campaign took place in Wisconsin — a debate among eight contenders from the Republican Party of the USA for the country's top position.
Empirical studies show that since the mid-1920s, the excess return of the US stock market under Republican presidents has been on average significantly lower than under Democratic presidents. Differences in returns are recorded both for the entire period and for individual subsamples, including several separate decades. Currently, one of the most popular hypotheses explaining this 'presidential puzzle' is the following assumption: investors tend to change their risk attitude depending on current economic conditions, which in turn affects both their electoral behavior and the required risk premium and future excess stock market returns.
According to the political cycles model developed by University of Chicago finance professors L. Pastor and P. Veronesi, in the event of economic crises, risk aversion is high and the required compensation for the risk of investing in stocks increases. In addition, the number of voters voting for Democratic candidates, who tend to support increased social spending, also rises. Conversely, when the economic situation is stable, the demand for social insurance falls, the risk premium required by investors is limited, and a Republican Party candidate advocating for lower business taxes is more likely to win. At the same time, when economic conditions are such that risk aversion is neither high nor low, the model cannot predict election outcomes.
It is worth noting that the news of a Republican Party candidate being elected president has a more positive impact on the American stock market (the likely tax reduction leads to an increase in expected free cash flows for equity owners), however, in the long term, the scale of the 'presidential puzzle' effect is more significant.
Source: National Bureau of Economic Research.
