Do elections move stocks?

The result of the EU referendum caused stocks to plunge and sterling to fall. Speculation about a second referendum, a new election and another vote in Scotland could also cause instability. However, it isn't the only major political event taking place this year. While attention is focused on Cameron, Corbyn and Johnson, the contest between Trump and Clinton for the White House is under way. So how much do US elections affect stockmarkets?

While the UK has traditionally had elections at irregular intervals, the US has had regular four-year presidential elections since 1792. This makes it relatively easy to look at the impact of the political cycle on the stockmarket. The consensus is that stock returns tend to be lower in the first two years of a president's term, and higher in the second half.

For example, a recent study by Peter Lee of UBS found that between 1920 and 2013 the stockmarket had average real returns of only 4.13% and 4.41% respectively in the first two years after an election. However, in the third and fourth years this increased to 10.35% and 6.12% respectively.

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Why does this occur? One explanation for this is that politicians assume that the electorate has a short memory. So they tend to get their most unpopular measures, such as tax rises and spending cuts, out of the way in their first two years. Since such measures tend to reduce growth, stocks perform poorly. They then embark on generous fiscal policies to bribe voters in the run-up to an election, which enables stocks to recover.

The Federal Reserve may also play a role. It is supposed to be independent, but the president appoints the Fed chair, giving him or her considerable leverage. A 2006 study by Kevin Grier of George Mason University found clear evidence that monetary policy followed the presidential election cycle, while a 2003 study by John Boschen of the College of William and Mary concluded that loose central bank policy in the run-up to elections was responsible for spurts of inflation during the 1960s, 1970s and 1980s.

The political affiliation of the president also seems to have an impact on the returns that investors can expect. The conventional wisdom is that the Republican party is better for investors and business, given its support for lower tax rates and lower levels of regulation. But the opposite seems to be the case. Bespoke Investment Group found that since 1901 the stockmarket went up by an average of 7% during the time a Democrat was in the White House, compared with 3% for a Republican.

In the interests of political balance, it's important to note that the study focuses on the date the president formally assumed office. Since this is ten weeks after an election, it may be that the market is initially too pessimistic about the result, rather than Democrats necessarily being better for the economy.