Midterm elections, Resolution of political uncertainty, and U.S. equity market premiums

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1 Midterm elections, Resolution of political uncertainty, and U.S. equity market premiums Q Group Fall 2018 Conference Montage Laguna Beach October 15, 2018: 10.45AM Noon Kam Fong Chan University of Queensland, Australia Terry Marsh U.C. Berkeley and Quantal International

2 Background Reference: Equity premiums in the Presidential cycle: The midterm election resolution of uncertainty, available on SSRN:

elections, winter effect/sad, Sell-in-May etc.

3 Presidential cycle between 1815 and 2015 Two centuries of data, with 50 Presidential cycles Equity market premiums over the cycle Outline Midterm elections, winter effect/sad, Sell-in-May etc. Mutual fund flows and macro indicators EPU, tail risks? Lost CAPM, IVOL Pre-scheduled announcements in general?

4 Timeline for Presidential cycle: Obama 2 nd term as example 2016 election year 2 nd year in Presidential cycle 1 Nov th year in Presidential cycle 1 Nov Nov 2018 Trump 1 Nov st year in Presidential cycle 1 Nov rd year in Presidential cycle Tonight s bar discussion: Will 2018 midterm be different? Winter year 3 (Nov 14 Apr 15) Midterm election is in Nov 2014

5 Average cumulative wealth in each presidential year Sample period: 1815:01 to 2015:12 Year 1 Example: Invest from Nov 2012 (Presidential election) for 12 mths Year 2 Example: Invest from Nov 2013 for 12 mths 85% Year 3 Example: Invest from Nov 2014 (midterm election) for 12 mths Year 4 Example: Invest from Nov 2015 for 12 mths

6 Average monthly equity premium over the past 200 years Average annualized equity premium from 1815:01 to 2015: % 0.6% 4.1% 0.9% Winter months in year 3 Example: Nov 2014 to April 2015 Summer months in year 3 Example: May 2015 to Oct 2015 Winter months in other years Examples: Nov 2012 to Apr Nov 2013 to Apr Nov 2015 to Apr 2016 Summer months in other years Examples: May to Oct May to Oct May to Oct % 0.9

7 Regression analysis r t = α + β 1 ME t 5:t 1 + β 2 ME t + β 3 ME t+1:t+5 +γ 1 PE t 5:t 1 + γ 2 PE t + γ 3 PE t+1:t+5 + e t r t = monthly equity premium (in annualized %) ME t 5:t 1 =1 for June through October prior to the midterm and 0 otherwise ME t =1 for the November midterm election and 0 otherwise ME t+1:t+5 =1 for December through April after the midterm and 0 otherwise PE t 5:t 1, PE t and PE t+1:t+5 are analogous dummy variables for the Presidential election

CAPM is lost most of the time but re-appears post-midterms Data: FF25 size & B/M sorted portfolios + FF49 industry portfolios Sample period: 1927

8 CAPM is lost most of the time but re-appears post-midterms Data: FF25 size & B/M sorted portfolios + FF49 industry portfolios Sample period: Fama-MacBeth test results: (t-stats are parenthesized) post r t+1 = βt (0.15) (3.09) r t+1 other = β t (3.01) (0.03)

9 So is IVOL, lost most of the time but re-appears post-midterms The same goes with idiosyncratic volatility, which is (spuriously) negatively related to expected return most of the time but has the expected positive relationship in months after midterms Data: FF25 size & B/M sorted portfolios + FF49 industry portfolios Sample period: Fama-MacBeth test results: (t-stats are parenthesized) post r t+1 = IVOLt (5.55) (0.67) r other t+1 = IVOL t (3.51) ( 2.62)

And also the lottery-like `MAX effect and also the MAX effect, which is (spuriously) flat most of the time but has the expected positive relationship with the stock expected return in months after

10 And also the lottery-like `MAX effect and also the MAX effect, which is (spuriously) flat most of the time but has the expected positive relationship with the stock expected return in months after midterms Data: FF25 size & B/M sorted portfolios + FF49 industry portfolios Sample period: Fama-MacBeth test results: (t-stats are parenthesized) post r t+1 = MAXt (4.83) (1.73) r other t+1 = MAX t (3.54) ( 0.39)

11 Post-midterms versus post-presidential elections Mean=13.9% Mean=13.1% Mean(r months after midterms ) in each Presidential cycle Mean(r months after midterms ) Mean(r months after Presidential ) in each Presidential cycle

12 We perform various robustness tests We rule out obvious suspects Time period: CRSP value-weighted index ( ) + Goetzmann et al. s (2001, Journal of Financial Markets) for pre-1926 data Results are persistent in sub-periods, and stronger post-1970 Statistically significant Pass the p-hacking thresholds of Harvery et al. (2015, RFS) and Ross (2017, J. of Portfolio Management) Pass bootstrapping test Robust to outliers and to different proxies for the U.S. equity market index We tested on post-1890s DJIA, CRSP equal-weighted index, Schwert s pre-1927 data, S&P500 futures etc January effect We show that it is not a manifestation of the January effect Cross-section data from 1927 to 2015 We tested on cross-section individual stock data using 1.16mil monthly observations for 8,165 firms Mutual fund data We tested on Morningstar mutual (equity & money market) funds and CRSP U.S. mutual equity fund data January effect It is not a manifestation of the January effect Macroeconomic news announcements No evidence that good macroeconomic news is released disproportionately more in post-midterm winter months than in other periods Macro indicators Next slide.

13 Macro, Treasury and other indicators 6.5% Pre-midterm months Post-midterm months Post-Presidential months Uncertainty rises Uncertainty falls -0.2% 17.2% 10.6% 3.1% 3.9% 3.0% ERR GDP Gross domestic product (p.a.) Equity real returns (p.a.) IP Industrial production (mthly growth) Post midterm months vs other months Changes in Fed funds rates (bps) 4.5% 1.7% Treasury excess returns (p.a.) FF Treasury % -1.7% 1.1% 6.6% 4.4% Private Real private spending (p.a.) Real government spending (p.a.) Public Civilian employment (mthly growth) EMP 1.5% 1.3% -1.9% 3.5% 5.5% 3.1% 1.2%

14 6-mth moving averages of year-to-year changes in Baker, Bloom and Davis EPU 16% 14% 12% 10% year 1 year 2 year 3 year 4 100% 90% 80% 70% EPU drops i.e., reduced uncertainty post midterms 8% 60% 6% 50% 4% 2% 40% 30% 14% 12% year 1 year 2 year 3 year 4 100% 90% 0% -2% J M S J M S J M S J M S 20% 10% 10% 8% 80% 70% -4% 0% 6% 60% Historical news-based EPU ( ) 4% 2% 0% -2% J M S J M S J M S J M S 50% 40% 30% 20% -4% 10% -6% 0% Notes: Dark shade: Nov midterm Light shade: Dec April after midterm EPU based on news, tax code changes and two measures of economic forecaster disagreements ( )

15 Variance risk premium and bond spread year 2 year 1 year 3 year 4 VRP and bond spread drop i.e., reduced uncertainty post midterms year 2 year 1 year 3 year J M S J M S J M S J M S Variance risk premium, in % ( ) J M S J M S J M S J M S Notes: Dark shade: Nov midterm Light shade: Dec April after midterm Moody s Baa Aaa, in bps ( )

16 CBOE SKEW and Kelly-Jiang tail risk measure year 1 year 2 year 3 year Reduced uncertainty post midterms year 1 year 2 year 3 year J M S J M S J M S J M S CBOE SKEW ( ) J M S J M S J M S J M S 110 Notes: Dark shade: Nov midterm Light shade: Dec April after midterm Kelly-Jiang (2014, RFS) cross-section tail index ( )

17 Evidence in portfolio flows: SAD or change in political uncertainty? Kamstra et al. (2017, JFQA) Aggregate investor flow data reveal investor preference for safe mutual funds in autumn and risky funds in spring Kamstra et al. (2017)

18 A priori importance of midterms Alesina and Rosenthal (1996, p. 1334, Econometrica) stress that this high uncertainty environment is typical in the period between the Presidential election and the subsequent midterm election:...the Presidential election resolves only the uncertainty about the President's identity. In the two years between the presidential election and the midterm election, the voters acquire further information about Presidential competency, personality, and policies... This makes the midterm election a key event in the Presidential cycle, and empirical studies have confirmed its importance and the uncertainty attached to it. During the pre-primary period the year following the mid-term elections the field of presidential candidates takes shape. The race for campaign talent and money, sometimes called the invisible primary unfolds. The candidates make their pitches in a variety of venues and forums. Differences on issues between the candidates begin to crystallize. Ad campaigns start. Some candidates pull ahead, and a few make early exits. (Pre-Primary Period: Race for the White House, Democracy in Action, 2016; available at As a specific case, a Washington Post headline on August , some two-plus years prior to the November presidential election, proclaimed: Reagan Described as Ready to Campaign Hard and Early for the Presidency (Lou Cannon). SITE conference: Political uncertainty and equity market premium

19 Pre-scheduled events Federal elections o Equity premiums in the Presidential cycle: The midterm election resolution of uncertainty (in SSRN depository) Macroeconomic announcements - FOMC, inflation and unemployment 0 in different political regimes o Work-in-progress Corporate earnings announcements o Preliminary work o Introducing news SITE conference: Political uncertainty and equity market premium

20 Average daily premium (bps) for 10 Fama-French industry portfolios By industries 25 HiTec 20 Other Hlth 15 Shops Manuf Durbl 10 Telcm NoDur Enrgy Utils Enrgy Hlth 5 Utils NoDur Shops Manuf Other Durbl Telcm HiTec Beta Blue Red = Announcement days in Democratic Administrations = Announcement days in Republican Administrations 20

Performance of Dow Jones Industrial Average: micro and macro-level analysis. Luis Palacios Rabih Moussawi Denys Glushkov Bob Zarazowski

Performance of Dow Jones Industrial Average: micro and macro-level analysis Luis Palacios Rabih Moussawi Denys Glushkov Bob Zarazowski 1962 1963 1964 1965 1966 1967 1968 1969 197 1971 1972 1973 1974 1975