Matthew Downs and Dr. Steven Thorley, Economics
Many factors influence the trading prices of securities listed on the New York Stock Exchange. Politicians, both Democratic and Republican, decide on an array of policies and tax laws that have a substantial affect on all areas of the market. In addition to this, as the economist John Maynard Keynes correctly predicted, government policies such as spending can have an enormous impact on the welfare of the economy.
How does Wall Street deal with the impact politicians have on the market? Our hypothesis was that Wall Street favors Republicans, because their policies are more beneficial for business. An extensive review of literature was conducted and we found little research had been conducted on this topic. The lack of research in this area sparked our interest in investigating the topic further.
The first step was designing a study that could determine what, if any, impact Democratic versus Republican candidates had on the market. Obviously, the single most powerful politician in the country is the President. His policies and decisions have a profound impact on the direction and welfare of the country. This was especially apparent following the stock market crash of 1929 leading to the Great Depression. President Roosevelt, in an attempt to stimulate the economy, started what was then an unprecedented program of government spending.
In 1937 politicians, especially Roosevelt, grew worried about the “excessive” amount of government spending. Government spending was cut back by $1 billion which led to the gross national product falling by more than $5 billion, It was now obvious that the government’s spending indeed had a profound affect on the economy, so much that cutting it led to dire consequences. This is just one of several examples used to illustrate the impact governmental policies have on the economy. Our study focused specifically on equity markets and the impact potential Presidential candidates had on them.
This study was designed to test our hypothesis by determining if there was a correlation between the probability of each Presidential candidate winning the election (as measured by the Iowa Electronic Presidential Elections Market futures contracts) and the price of stocks in various industries. If Wall Street favored Republican Presidents then stock prices should rise as the probability of a Republican President winning the election rose. On the other hand, stocks should fall in price as the probability of a Democratic President taking office rose.
We chose to use the IEM because capital markets are paying attention to it since the IEM has forecasted election results with surprising accuracy since its formation in 1988. It ended up predicting the ’88 and ’92 Presidential elections within two-tenths of a percentage point — which far outperformed national polls.
The Iowa Electronic Presidential Elections Market is a real-money winner-takes-all futures market in which contract payoff depends on the outcome of Presidential elections. This market is operated by faculty at the University of Iowa. Payoffs in this winner-takes-all Presidential market are determined solely by the candidate who receives the largest number of popular votes in the November election, Contracts in the candidate receiving the largest number of popular votes will payoff $1 each; all others will expire worthless.
Each contract has a Bush unit and a Clinton unit which together cost $1 to buy. Traders make their bet by selling the unit they think will lose. For example, the Clinton unit of the contract could sell for 80 cents which means a Bush unit is selling for 20 cents. Movements in the price of a Bush or Clinton unit reflect the market’s perception on who will win the election. Because the total cost of a contract always equaled one, the market price could be seen as the probability of each candidate winning.
Our next step was to analyze the percentage changes in price of a Clinton or Bush unit of the contract and compare the change to the percentage change of stock prices in various industries. Although stock prices from many sectors were analyzed, only the health care stock portfolio will be discussed in this paper because it was a major issue in the 1992 Presidential election and it led to some interesting results.
Our results showed that there was an inverse relationship between the probability of Bush, the Republican candidate, winning the election and the price of health care stocks. In other words, as the probability of Bush winning the election went up, the price of health care stocks went down. On the other hand, as the probability of Clinton (the Democratic candidate) winning the election rose, so did the price of health care stocks. Thus, the relationship we found was exactly the opposite of our hypothesis.
Additional research on the matter indicated that Wall Street was uncertain as to what Bush’s policies on health care reform would be. Clinton did not have a concrete plan either, but Wall Street felt his plan was going to be beneficial to health care related companies. The results from our study tend to support these views.
As stated many stocks from different sectors were analyzed and correlated to the data from the IEM. However, no correlation of statistical significance was found that confirmed our hypothesis. This may be due to the fact that Wall Street looks more at each candidates policies and less at party affiliation. Our study did not incorporate an analysis of which political party controlled Congress and the possible influence that may have on various stock portfolios.