Northern Illinois University

NIU Office of Public Affairs

News Release

Contact: Joe King, NIU Office of Public Affairs
(815) 753-4299

March 18, 2008

Buyers should beware of truisms
about stocks and politics, NIU researcher says

DeKalb, Ill. — When it comes to the intersection of politics and the stock market, conventional wisdom is not always so wise, says NIU Professor of Finance Gerald Jensen.

Jensen has co-authored a number of studies that examine some of the favored truisms that the investment community trots out at election time and found that many of them just aren’t accurate.

For instance:

Financial pundits like to say that political gridlock (when one party controls Congress and another the White House) is good for the market. However, a thorough analysis of stock market performance during such times found the claim to be baseless.

As the presidential primary season begins to sort itself out, commentators are renewing debate over whether the stock market performs better under a Republican or Democratic administration. The answer, according to Jensen’s research: neither. Monetary policy set by the Federal Reserve Bank far overshadows any impact that the president’s party affiliation might have.

The third year of any presidency also is said to be a boon for the markets. Sure enough, historical data backs that up. However, say Jensen and his colleagues, evidence once again indicates that the phenomenon has much more to do with the Fed loosening the reins on credit than with any fiscal policy flowing from the White House.

“The conventional wisdom behind these sorts of statements is built on patterns,” says Jensen. “But patterns can be coincidental and you need to look at underlying variables. In our research we found that while there were lots of hypotheses that allegedly explain these truisms nobody had looked for statistical causes. We found that a lot of things people claim just aren’t true when you control for monetary conditions.”

The impact of monetary policy is dramatically demonstrated in the latest paper, “The Presidential Term: Is the Third Year the Charm?” which appeared in the Winter 2008 edition of The Journal of Portfolio Management. The paper is co-authored by Jensen and his colleagues, Professor Scott Beyer of the University of Wisconsin Oshkosh and Robert Johnson the deputy CEO at the CFA Institute.

After evaluating quarterly returns from 1957 through 2004, the researchers found that equity returns are significantly higher in the final two years of a presidential term than in the first two years and peak during the third year. In that third year, small-cap stocks generated an average annual return of more than 38 percent.

Some have tried to attribute that bump to presidents trying to manipulate the market (say through increased government spending) to improve chances of re-election, or at least trying to help their party retain control of the White House. They claim that presidents make unpopular fiscal moves during their first two years in office, then act expansively the rest of the way. Others claim that the jump can be attributed to investor optimism at the re-election of a popular president or the ouster of an unpopular leader in the upcoming election.

Jensen et al. examined several factors linked to those suppositions but none explained the phenomenon nearly as well as Fed policy fluctuations. Examining Fed policy and determining when the bank was in an expansive mode (lowering interest rates) they found that, over the years studied, the Fed pursued an expansive course in 23 quarters in the first, second and fourth years of presidencies. During the third year of those presidencies, Fed policy was expansive in 31 quarters. Furthermore, the federal funds premium, which indicates the degree of monetary stringency, suggests Fed policy stringency in the third year was less than half what it was during the first two years of the presidential cycle.

“Our analysis finally provides some rationale for the “third year effect,” a phenomenon that has perplexed investors for years,” says Jensen.

Looking into the facts behind such assumptions has become something of a cottage industry for the researchers.

“After we did our first political paper, I thought that would be the end of it, but we’ve done three more since,” says Jensen, who finds that the topic appeals to a wide range of people. “There are two topics that most people like to talk about – stocks and politics, so blending the two is a natural.”

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