Academic journal article Journal of Economics and Finance

Economic Policy and the Presidential Election Cycle in Stock Returns

Academic journal article Journal of Economics and Finance

Economic Policy and the Presidential Election Cycle in Stock Returns

Article excerpt

Published online: 12 April 2011

© Springer Science+Business Media, LLC 2011

Abstract Many papers in the academic literature have documented a "Presidential Election" cycle in stock returns. Prior literature also documents that stock returns appear to be influenced by economic policy. The goal of this study is to examine the tools of fiscal and monetary policy to test for the presence of a presidential election cycle. The findings strongly suggest that the presidential election cycle in stock returns and the government's economic policy influence on stock returns are two separate phenomena. Moreover, it is much more likely that stock returns are influencing economic policy rather than the other way around. However, the findings also suggest that tax legislation may drive the Presidential Election Cycle.

Keywords Stock Returns * President * Election Cycle * Economic Policy * Tax Legislation

(ProQuest: ... denotes formulae omitted.)

1 Introduction

Many studies in the finance literature have documented a "Presidential Election Cycle" (hereafter, PEC) in U.S. stock returns,1 in which returns are reliably larger during the 2nd half of the president's term than during the 1st half.2 Allvine and O'Neill (1980) conduct one of the earliest studies by examining returns over the period 1961-1978. They find evidence strongly suggesting that stock returns are correlated with the PEC. Huang (1985) examined the period 1832-1979 and also found average annual common stock returns to be significantly higher during the second half of the president's term. More recently, Johnson et al. (1999) study S&P 500 returns and small stock returns, finding that both are higher during the second half of the president's term and Booth and Booth (2003) find that the cycle is robust to several business cycle variables. Also, Sturm (2009) finds that the PEC affects January's ability to predict stock returns for the remaining 11 months of the year.3

These long-lasting findings are perplexing for at least two reasons. First, they contradict market efficiency which implies that such abnormal returns should be arbitraged away as traders anticipate the upcoming cycle. This procediue has been well-documented at least as far back as Black (1971). Second, the returns appear to offer investors a clear path to excess wealth. Perhaps most perplexing, however, is a clear understanding of the PEC's cause. Several have conjectured a cause, but convincing evidence is lacking. For example, Stovall (1992) offers an explanation for the cycle, arguing that campaign timing causes the administration and the Federal Reserve Board to be at their "tightest" during the early quarters and at their "most accommodating" during the later quarters of the foiu-year election cycle. Zhao et al. (2004) also provide an explanation for the PEC, arguing that the economy is stimulated during the 2nd half of the president's term through fiscal, economic and administrative policies to enhance the reelection chances of the incumbent president's party. Booth and Booth (2003) also offer an explanation of the cycle, but together, the basic argument is that the time remaining to the election (or reelection) influences the administration's economic policy decisions, which in turn influences stock prices. If this argument is true, then we would not only expect to see a PEC in stock returns, but also in the tools used to carry out the economic policy. This notion forms the motivation for this study.

The government's economic policy is typically categorized as either fiscal policy or monetary policy. Fiscal policy can be more directly controlled by the president's administration because it is carried out through the government's tax laws and its spending policy, thereby forming the government's budget. The tools of monetary policy, however, are controlled by the Central Bank (i.e. the Federal Reserve) and include the setting of key interest rates and banking reserves to influence the supply of money in the economy. …

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