Vito Gala, assistant professor of finance at London Business School, working with Frederico Belo at University of Minnesota, and Jun Li at University of Texas at Dallas, found that political cycles have a large impact on stock investments and that choosing the right strategy, according to which party is in power, can, literally, pay dividends.
They examined data from as far back as 1929, when Herbert C. Hoover was in power, through to Obama in 2009, charting industries’ exposure to government spending through eleven democrat and eleven republican terms.
Under Democrats, high exposure sectors outperformed low exposure sectors by six per cent; while under Republicans they underperformed by about five per cent per year. They found such a pattern to hold even when adjusted for business cycles.
A simple strategy of buying sectors most exposed to government spending when a democrat government is in power, and vice versa for Republicans, would have earned about seven per cent a year risk-adjusted return.
Among the industries with the highest exposure to government spending, they identified aircraft, defence and construction, and secondary industries such as steel and mining, while those with the lowest exposure include tobacco, alcohol and food products. And as the election results roll in, they advise investors to keep a close eye on the fall-out to get the most bang for their buck:
“If the Democrats win, investors should buy stocks from industries with high exposure and sell their low exposure stocks. Conversely, if the Republicans win, the strategy should be reversed. Investors should sell their high exposure stocks and buy low exposure stocks.
“Based on historical evidence, over the presidency, and particularly during the second and third year, they should see nice returns.”
The main driver of such discrepancy between Democrats and Republicans comes down to systematic differences on each party’s government spending policies.
However, the market has, in the past, proved slow to price in such systematic differences, thus leaving scope for profit. If such slow adjustment persists this time around, the simple strategy will also keep working over the next presidency.
View the research paper here: http://dx.doi.org/10.1016/j.jfineco.2012.08.016