Why You Should Cast Your Vote at the Polls, Not in the Markets

As election season heats up, emotions are likely to hit a feverish pitch. Each party will have you believe the other will be devastating for any number of reasons. The economy gets frequent mention, meaning it can be easy to get caught up in the idea that the election will affect your money. Don’t get us wrong—the outcome of an election can hit your wallet. But when it comes to the broader economy and the markets, the impact on your portfolio may not be as severe as you think—unless you let it.

No doubt, industries and stocks can be highly sensitive to polls or proposals from one day to the next, and you should factor politics and policy into your overall investment equation. But while presidents can nudge the economy in one direction or the other, the overall impact from one administration to the next is usually mixed. And the party in charge is not the biggest factor in how markets behave. That’s because the $28 trillion U.S. economy is too big and complex to significantly sway from its natural trend rate of growth.

Every economy undergoes natural cycles of expansion and contraction that are hard to interrupt. So how much impact does the party in control have? A review of history shows it’s had less to do with any particular party in office and more to do with the business cycle. A president who takes office late in the cycle is more likely to see poor market performance. One who takes the oath early in the cycle will likely see better performance.

Measuring where we are in the economy

Over time, the U.S. economy has a natural trend rate of growth—think of it like the speed limit. However, just like when you’re driving at rush hour, the economy doesn’t maintain a consistent speed. Instead, it drifts through periods of expansions followed by contractions, sometimes racing well above its speed limit or cruising well below it. This movement around its long-term trend is known as the business cycle (a single cycle contains one boom and one bust), and history shows this is a natural, inevitable process. 

One way you can gauge where we are in the business cycle is to look at the output gap. If you’re not familiar with the term, the easiest way to think of it is as an economic measure of the difference between the actual output of the economy and its potential output. When the gap is positive, economic output is greater than its potential and is a sign of an expanding and potentially overheating economy, which usually happens later in the business cycle. A negative output gap is the opposite and indicates there is room to grow—something you often see earlier in the business cycle. Typically, we look at gross domestic product for actual output and estimates of the average amount the economy can produce with its workforce (and how productive workers are) to calculate its potential output.   

And, as it turns out, the output gap (i.e., the business cycle) and stock valuations are pretty good indicators of how the market will fare under a president, regardless of party affiliation. 

Mind the output gap

As you can see in the chart below, presidents who take office when the output gap is negative, the unemployment rate is high, inflation is low, and market valuations are cheaper (often after a recession) have typically presided over good economic and market environments. Indeed, every president taking office during an early/mid-cycle has seen double-digit market returns, and in only three instances has there been a recession. The recession during the Carter administration occurred at the end of his tenure and didn’t have a large impact on equity markets. The recession during Ronald Regan’s tenure occurred at the beginning of his time in office and was coincident with the beginning of the end of the inflationary period of 1966–1982 that the markets cheered over the coming years. Lastly, the recession of 2020 was near the end of Trump’s administration and was tied to the shorter-term impacts of COVID. 

By contrast, presidents who take office when the output gap is positive, the unemployment rate is low, inflation is elevated, and market valuations are expensive have typically presided over sub-par economic and market environments. Indeed, five of the seven presidential terms that began late in the business cycle experienced a recession while in office. The two presidents who began terms late in the business cycle but didn’t preside over a recession were Lyndon Johnson in 1964 and Bill Clinton, who began his second term in 1996. Both Johnson and Clinton exited office a few months before a recession began (Dec. 1, 1969, and March 1, 2000, respectively). The Clinton administration presided over one of only two late-cycle presidential terms that saw double-digit market returns. The strong market performance during Clinton’s second term was likely due to there not being a recession and the tech boom of the late 1990s that left the economy and market valuations stretched. The other double-digit return occurred during George H.W. Bush’s term that began in 1988, when market valuations where cheap after the stock market rout of late 1987.

While there are many variables that impact a presidency, it appears overall the business cycle serves as a large driver of economic and market outcomes. Overall, early-cycle presidencies see an average starting inflation-adjusted price-to-earnings ratio of 20.6 and an unemployment rate of 7 percent. This has led to markets returning an annual average return of 14 percent. Late-cycle presidencies have started with an average inflation-adjusted price-to-earnings ratio of 26.1 and an unemployment rate of 4.7 percent, which has led to an average return of 6.3 percent over the next four years.  

This takes us to today and the upcoming election: Currently, the output gap is hovering in slightly positive territory with the unemployment rate at 3.7 percent, inflation is elevated, and the inflation-adjusted price-to-earnings ratio is 29.6. If current valuations and unemployment readings hold steady until inauguration, the winner in November will take office with the inflation-adjusted price-to-earnings ratio at the second highest level and the second lowest unemployment rate of any of the administrations since 1960. While the output gap can become more positive, the economic cycle can last longer, and markets can continue to climb, it appears that no matter who is elected, it will be hard for him to avoid presiding over a recession for the next four years.

Expect the unexpected

As you can see from our data, it appears that the success or failure of a president’s economic policies are significantly influenced by the economic cycle. However, it isn’t the only outside influence that can derail even the most comprehensive economic plans. A major crisis or global event can throw a wrench into any administration’s time in office. We saw that happen during the coronavirus pandemic and before that in the aftermath of 9/11, the Great Financial Crisis, and a host of other challenging times throughout history. Events like these can be game-changers that put administrations on the defensive, forcing them to react rather than implement a policy vision.

Markets don’t always follow “the script”

Of course, this isn’t to say that policy and politics don’t matter. Within the broader economy that is hard to impact, presidents and administrations often create polices that attempt to shift growth toward certain sectors, industries or companies. However, even within specific sectors of the economy, variable and secular trends can overpower a president’s actions. For example, during former President Trump’s time in office, energy was the worst-performing sector—actually producing negative returns, while the U.S. stock market as a whole averaged gains of 16 percent per year during his term—this despite Trump being viewed as in favor of expanding domestic oil production. Contrast that with the tenure of President Biden, who is viewed as less in favor of traditional energy and has focused on transitioning the country away from gas, oil and coal. During Biden’s time in office, the energy sector has been the best-performing of the 11 sectors that make up the U.S. equity market. The likely cause was the impact from COVID on energy demand at the end of the Trump administration versus the global economic recovery as COVID faded and demand for oil jumped during Biden’s term.

Issues change, but your approach shouldn’t

While the candidates and issues change during every election cycle, we believe the backdrop and advice remains the same: Stick to a long-term financial plan that harnesses growth through diversified investments while also managing risk.

In the weeks following the election there will probably be some short-term turbulence as markets digest the results. However, we believe that most political outcomes this fall will ultimately yield relatively calm markets going forward. A contested election that puts results in doubt or a single-party sweep could amplify volatility. However, we believe the size and breadth of the economy will prevail as the driving force for the markets.

Even if there are a few surprise outcomes, any sell-off, we believe, would be a “kneejerk” reaction. We encourage you to avoid following the herd if this happens. Over time, the market will eventually digest the new policy backdrop and likely move higher as uncertainty lifts and the focus turns to what is next.

Your financial plan should outlive campaign promises 

Voting is a treasured tradition in the United States, and we encourage you to exercise the right to cast a ballot come the second Tuesday of November. However, when it comes to your money, we believe it’s risky to let your political beliefs dictate your investment decisions. That’s because often the biggest obstacle to long-term performance is giving in to your emotions and abandoning your strategy. Regardless of the political stakes that accompany presidential elections, stock market performance tends to be strong; investors who have stayed the course have seen the stock market average an 11.4 percent total annualized return since 1950, regardless of which party’s candidate comes out on top. It’s important to consider the damage to a long-term financial plan as a result of missing out on these periods of positive returns if you allow your political views to dictate your money moves.

Your decision to work with us to manage your money lets you grow your wealth while protecting everything you’ve worked so hard for—no matter where you’re starting from. Let us help you resist the urge to change your long-term investment strategy this election season by looking past sensationalized media headlines and focusing on the importance of staying invested through multiple market cycles and events.   

All investments carry some level of risk, including the potential loss of all money invested. No investment strategy can guarantee a profit or prevent against loss. Indexes referenced are unmanaged and cannot be invested in directly. Investment examples are for illustrative purposes only and not indicative of any investment.

The opinions expressed are those of Northwestern Mutual as of the date stated on this material and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any investment or security.

Commentary is written to give you an overview of recent market and economic conditions, but it is only our opinion at a point in time and shouldn’t be used as a source to make investment decisions or to try to predict future market performance. To learn more, click here.

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