An election year is often a time of uncertainty for societies that practice a democratic or parliamentary form of government. Issues facing the nation's economy, judicial system, as well as future control over the government's legislative branch in coming midterm elections make their way to the forefront during the presidential election cycle.
From a trading and investing standpoint, the basic rule of thumb regarding the marketplace of financial securities is simple: Traders and investors do not appreciate looming uncertainty. The U.S. presidential elections provide a voracious debate upon the direction of the country, and more importantly, provide uncertainty unto the marketplace.
Equities, futures and forex markets are all interested in the relative strength of the United States dollar, and ultimately that strength is based upon the economic health of the nation as a whole. The U.S. presidential election has a great bearing on the direction of the domestic economy, and the potential influence on the USD itself can be substantial.
Election Day Trading
Election Day in the United States is the Tuesday following the first Monday in November. For the period dating back to 1792, the U.S. Presidential Election Day was held as a national holiday. It was not until 1984 that the stock market was open on election day, with the reason being cited that the market provided a necessary service to the public. At the time, skeptics maintained that insider trading could become a major concern as political insiders could use exit polling data in order to take positions in economic sectors likely to be affected by the results of the election. Eventually, the skeptics' cries were drowned out, and the policy of open trading on Election Day became the norm.
Although voting actively takes place during trading hours, the official electoral results are not available until Tuesday evening. The time lag effectively nullifies any potential impact of the election's result upon the marketplace during peak trading hours. As information systems technologies have advanced, exit polling data has become readily available to anyone who wants to seek it out; thus, the threat of insider trading based upon privileged exit polling data is not as great as in previous decades.
Presidential Election Cycle Theory
The impact of political events upon global markets can range from subtle, to substantial, to potentially catastrophic. One theory that attempts to establish a correlation between the result of U.S. presidential elections and the valuation of equities is the "presidential election cycle theory." In basic terms, the "presidential election cycle theory" is a belief that stock market trends can be predicted by the four-year presidential cycle. The theory dates back to 2004 and was developed by market historian Yale Hirsch.
In practice, the presidential cycle theory breaks down the performance of equities according to the four-year presidential term. The first year after a new president is elected often sees weak performance in equities. During year two, the performance of equities shows a gradual increase, with years three and four showing the strongest returns. Many reasons for the appreciation of equities in years three and four have been cited, with popular explanations ranging from successful policy changes attributed to the new administration, to shrinking uncertainty facing the market in general.
Of course, much like everything to do with investing and trading, the rule can be fallible and an oversimplification. An example of the theory being ineffective occurred in the election year of 2008, with the Dow Jones Industrial Average posting an annual decline of 33.84%. According to the theory, year four of the presidential term was to be the strongest year of the cycle, but 2008 fell dramatically short of the theory's expectations.
An important caveat to the presidential cycle theory is that it is based upon four-year cycles and does not make special note of the final year of a two-term incumbent president. Since 1900, the S&P 500 has gained an average of 11.5% and has risen 83% of the time in year four of a presidency. However, over the same time period, the S&P 500 has fallen by 1.2% in year eight of a two-term incumbent president, with the market posting gains only 44% of the time.
The presidential cycle theory exists as only one part of the overall picture regarding the future strength of equities, and indirectly, the future strength of the United States dollar. Much like all indicators, the theory has its advocates and detractors, with most investors and traders respecting the theory as a timing device by which to enter or exit the market.
Anticipation Of New Monetary Policy: Pre Election Market Moves
The "strength of the U.S. dollar" is a popular topic within the campaign trail rhetoric of nearly all candidates running in the presidential election. Promises of job creation, national debt reduction and the creation of a strong national economy are often the vehicles by which a candidate promises to deliver a strong dollar. It is true that both the Republican and Democratic parties agree that a strong dollar is in the best interest of the country. However, the means of achieving this goal are very different.
Monetary Policy: Republican Party
Fiscal conservatism is the calling card of the Republican Party, with proposed monetary policy centered on national debt reduction and job creation within the private sector. The potential election of a Republican candidate is oftentimes construed as being a precursor to business-friendly legislation, lower taxation and a tightening of government spending.
In the midterm elections of 2014, the Republican Party was expected to take control of the United States Senate and introduce legislation that would contest the United States Federal Reserve's policies of low interest rates and quantitative easing practices. During the days leading up to the election, and in anticipation of the election's result and potential shift in policy, the USD traded at multi-year highs against the euro, Swiss franc and Japanese yen. Albeit an isolated example, and far from a concrete correlation, the mid-term elections of 2014 do illustrate the relationship between party politics and monetary policy facing the USD. As polling data became more concrete in the days before the election, traders found reasons to buy U.S. dollars, expecting a tightening of interest rates and a long-term appreciation of the currency.
Monetary Policy: Democratic Party
On the opposite side of the United States' political aisle is the Democratic Party, with monetary policy objectives centered on public sector job creation and increased governmental spending. Support for legislation concerning issues such as universal health care, education entitlements and extensive public works projects can all be attributed to Democratic governmental policy. Investors and traders are oftentimes bearish on the potential election of Democratic leadership, due to the widespread association of the Democratic Party to principles of socialism, large government and higher corporate taxation rates.
The 2012 presidential election provides an illustration of market conditions during an election in which a Democratic candidate comes out on top. The hotly contested election was often seen as a toss-up by political experts, and the currency markets showed just how uncertain the "experts" were. Tight yearly ranges, with modest variation in exchange rate valuations, were prevalent in EUR/USD, USD/CHF and USD/JPY. The somewhat-static market conditions facing these major U.S. dollar pairings are often cited to be the result of an upcoming period of uncertainty, and a trading strategy of "sit and wait" being adopted by traders and investors.
Over the course of 2012, many individual trading sessions involving the USD majors were volatile and chaotic. However, when compared on a yearly basis to non-election year returns, the trading ranges of USD majors for the year 2012 could be characterised as relatively tame.
The trading of USD major pairings in the run up to the 2014 midterm election and the 2012 presidential election can be useful when examining just how different USD valuations can behave when facing different election-year situations. Essentially, forex traders and investors can behave in nearly unpredictable ways when faced with the uncertainty of an election's outcome. Sometimes they are content to sit and wait, while other times the trading opportunity appears too good to pass up.
At the end of the day, economic complexities surrounding the dollar's valuation will be the driving force behind a sustained rally or prolonged downtrend. According to the presidential cycle theory, equities are likely to stagnate in the short term following an election, which could certainly hamper any uptrend in the value of the dollar. Ultimately, the U.S. dollar's long-term value is dependent upon many different factors, and the election year may just provide a few obstacles in the road rather than a complete change of course.
Any opinions, news, research, analyses, prices, other information, or links to third-party sites are provided as general market commentary and do not constitute investment advice. FXCM will not accept liability for any loss or damage including, without limitation, to any loss of profit which may arise directly or indirectly from use of or reliance on such information.
Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…