The 2004 presidential election is over, but the outcome may not matter—at least to the markets. Two new studies suggest that you should instead focus on Fed policy for clues on which way the markets may be heading.

By the time you read this, the race will be over; your preferred candidate will either be in or out of the White House. And as a voter, the outcome may matter to you greatly.

But does it matter to the stock market?

Two recent studies by the CFA Institute, in conjunction with several academic researchers suggest that investors would be better off focusing their attention on Federal Reserve actions rather than political outcomes.

 The Stock Market and Politics

Although previous researchers as well as conventional wisdom have tried to pin the performance of the stock market down to whether a Republican or Democrat is in the White House, a recent study conducted by researchers from the CFA Institute and Northern Illinois University College of Business suggests that market performance is more strongly correlated to Federal Reserve monetary policy.

The study, entitled “Don’t Worry About the Election, Just Watch the Fed,” appears in the Summer 2004 issue of the Journal of Portfolio Management.

Previous studies have linked the political landscape and monetary conditions to the performance of the security markets. However, factors have not been considered jointly when examining security returns.

Unlike the prior studies, the new study evaluates the impact on long-term security returns of three variables jointly:

• Security market returns relative to the political party of the president;
• Political gridlock; and
• The general monetary stance of the Federal Reserve Board.

In the study, researchers examined market returns during the election cycles from 1926 to 2000.

The researchers found that during the eight presidential administrations between 1969 and 2000, the returns on the S&P; 500 were much more closely correlated with monetary policy than with either the party of the president or whether there was political gridlock.

In fact, with the exception of the Carter presidency and the first Clinton administration, stocks always performed better when rates were falling than in periods of rising interest rates.

The study also debunks a long-held theory that markets do better in times of political gridlock—defined as periods when different parties control Congress and the White House. In fact, the study found:

• Large-cap stocks perform similarly whether gridlock is present or absent; and
• Small-cap stocks, contrary to conventional wisdom, actually perform much better when there is political harmony.

“There’s no question the president and Congress have significant impact on the economy, but it’s very simplistic to think that the president and Congress have done a bad job just because the economy and the markets aren’t as good as they were four years ago,” said Bob Johnson, executive vice president of the CFA Institute’s CFA Program division.

“There’s another variable that begs to be considered—the Fed.”

And just how much impact does the Fed have on stock returns?

 Markets and Monetary Policy

That was the subject of a similar but separate study, “Is Fed Policy Still Relevant for Investors?” conducted in June 2004 by the CFA Institute, and finance professors from Northern Illinois University, the University of Richmond and Texas Tech University.

The study compared market returns during different monetary periods over a 38-year period, starting in mid-1963. The Federal Reserve discount rate was used to define monetary policy:

• A series of discount rate decreases defined expansive policy periods, and
• A series of discount rate increases defined restrictive policy periods.

Within the 38-year timeframe, there were 21 different monetary periods—each period beginning with a change in direction of Federal Reserve monetary policy.

The study found that during times of restrictive monetary policy, the markets performed poorly, resulting in lower-than-average returns and higher-than-average risk. Stock returns during these time periods averaged just 2.84%.

Conversely, periods of expansive monetary policy generally coincided with strong stock performance, including higher-than-average returns and less risk. Stock returns during these time periods averaged 21.86%.

While initial analysis suggests that the relationship between the two has lessened throughout the years, the results were nonetheless consistent across policy periods, except for a single monetary period in the mid-1990s that coincided with the tech boom.

TABLE 1. Market Performance and Monetary Policy

The researchers also examined the performance of various market segments and investment strategies (based on market capitalization and value versus growth) during different monetary environments. It found that small-cap companies and those in cyclical markets are particularly sensitive to changes in monetary policy. In fact, companies in cyclical services, information technology and cyclical consumer goods such as automotive, media and hotel, restaurant and leisure industries performed 26% better during periods of expansive monetary policy than during periods of restrictive monetary policy.

The effects of policy changes were least pronounced for sectors such as utilities and non-cyclical consumer goods such as food and drug retailers and food, beverage and tobacco companies.

Table 1 presents a brief summary of the investment strategy performance findings.

The study also found that U.S. monetary policy had a significant influence on global markets, as evidenced by return patterns for five alternative stock indexes.

“The Federal Reserve’s management of U.S. monetary policy has a strong bearing on the stock market,” said the CFA Institute’s Bob Johnson. “While Americans closely follow the impact of rising and falling interest rates on their mortgages, they should also consider the potential effect on their investment portfolios.”

This article is based on two recent studies:

1. "Don’t Worry About the Election, Just Watch the Fed,” by Robert R. Johnson, Ph.D., CFA, executive vice president, CFA Institute; Scott B. Beyer, Ph.D., assistant professor of finance, Northern Illinois University; and Gerald R. Jensen, Ph.D., professor of finance, Northern Illinois University. It appears in the Summer 2004 issue of the Journal of Portfolio Management.

2. "Is Fed Policy Still Relevant for Investors?” by C. Mitchell Conover, Ph.D., CFA, associate finance professor, University of Richmond; Gerald R. Jensen, Ph.D., professor of finance, Northern Illinois University; Robert R. Johnson, Ph.D., CFA, executive vice president, CFA Institute; and Jeffrey M. Mercer, Ph.D., associate professor of finance, Texas Tech University.

The CFA Institute is a professional association that administers the Chartered Financial Analyst program and sets professional and performance-reporting standards for the investment industry.