What we can learn from the reaction of the stock market to a President Trump

By Ray Sturm, University of Central Florida

The global financial markets initially sank, recovered and then made solid profits when Donald Trump won the presidential election of the United States.

The Standard & Poor's 500 closed up 1.1 percent, as investors saw something positive from President Trump. That followed a night of panic, when futures contracts on that same index dropped 5 percent, and the Mexican peso, which has been a key indicator of investor confidence during this race, fell as much as 12 percent. , to a historical minimum.

While investors around the world summarize the results of the election, a central problem for them is how their assets will affect the results. But how does the markets react also tell us something about the future?

The fact that markets, specifically stocks, continue to fall or start to rise in the coming days may be a Useful indicator of how they will perform in the coming months and even years. In the case of the 2016 presidential election, investors will decide whether they think Trump will be good or bad for the economy, and more importantly, their investments, such as the 45th president.

The rest of us, investors or not, should pay attention.

In general, as expected, markets tend to rebound if investors believe that the winner of the election will be good for their investments and will fall if they consider otherwise .

Basically, everyone is betting on the future, some in the short term, others in the long term. In particular, they can become optimistic and buy more US stocks, for example, if they think the next president will create a more business-friendly business climate, perhaps by reducing tax rates, investing in the economy (leading to more growth). strong), reducing Regulation or reduction of uncertainty.

The research I published in 2014 offers evidence that early evaluation of the stock market tends to be a good predictor of how it will perform in the near future. In other words, investors issue their own votes, with their hard-earned dollars, on the outcome of the election: if more investors think that the election of the president of the United States will be good for the economy rather than bad, the prices of the shares go up and vice versa.

In my study, I examined market returns for the Dow Jones Industrial Average (DJIA), which includes 30 of the best-known US stocks, such as Microsoft and Boeing, covering 29 presidential elections from 1896 to 2011. I found two key evidences that can drive the performance of the investor's equity portfolio in the short and long term.

First, how the market reacts the day after the election seems to be an indicator of how it will perform during the remainder of the election year. If this pattern persists, then investors can expect stock returns from November 10 through December 31 to continue in the same direction as November 9 returns. This is generally known as the impulse effect, popularized in the academic literature by finance professors. Narasimhan Jegadeesh and Sheridan Titman.

In those 29 presidential elections that I examined, when the market "approved" the result by recovering the day after the election, the shares averaged around 3 percent for the rest of the year. When stocks initially fell, the market lost an average of around 2 percent during the period.

My second key discovery was that markets tend to change their minds in the second year in charge of a new president. That is, in cases where stocks were recovered during the first three days after an election, the market seems to regard the initial movement as an "overreaction" and vice versa.

Specifically, the DJIA lost an average of about 2.5 percent in the second year of a president if it gained a momentum of victory during those three days. When the president-elect was initially punished by investors, the shares returned around 12.5 percent in their second year.

The reason for this anomaly seems clear. Media attention to choice induces extreme beliefs among voters, including investors, which are reflected in business decisions as soon as results are known.

So, if the market reacts negatively to the outcome of the election and the president turns out not to be as bad as expected, then the market recovers. The opposite behavior occurs when the market reacts positively to the outcome of the election and, apparently, this behavior occurs frequently.

More generally, these findings seem to fit into a well-known phenomenon called the presidential election cycle, referring to the four years since a new president took office the oath of office.

Going back at least to the 1960s, the second half of a president's term, especially the third year, has almost always surpassed the first half. In the last 14 electoral cycles, returns in the third year of a period averaged about 16 percent, doubling the average every alternate year.

That means that for this year's elections, 2019 should be a good option for investors, regardless of how the markets react in the coming days.

Some have argued that the reason is that to enter a year of presidential elections, the president is motivated to keep his party in power. Therefore, it has an incentive to implement fiscal policies designed to give a boost to the economy, which is usually good news for a company's results, resulting in a positive return on shares.

The evidence that supports this theory, however, has been difficult to achieve. A study I published in 2013 suggested that fiscal policy could be behind the increase of the second half because most of the fiscal legislation is approved in the first two years of a president's term, so the economic impact is felt in the later years.

Research has shown that Democratic presidents have historically been better at actions than Republican presidents, but at the cost of higher inflation. So, how can investors expect their portfolios to perform now that the 2016 elections have ended?

If the record is a guide, the odds indicate that the market returns for the rest of 2016 must continue in the same direction as the returns for the day following the election. Yields for the year 2018 must be in the opposite direction to the accumulated returns for the three days after the election. Finally, 2019 will probably be a positive year independently.

Given the unusual characteristics of this choice, it is difficult to speculate whether these patterns will continue or not. This is the first time in history that the country can have a true stranger, without military or governmental experience, as president. Then, only time will tell if these patterns will persist.

However, Americans have cast their votes for president, and now investors will continue to cast their own votes on whether they believe he will be able to improve the economy. And that can provide valuable clues to the performance of the investor portfolio in the coming years.

Ray Sturm, Associate Professor of Finance, University of Central Florida

This article was originally published in The Conversation. Read the original article