With just 34 days till the US presidential election on 3 November 2020, the race is heating up.
President Donald Trump and Joe Biden faced off in their first Presidential debate this morning, one that soon descended into an unrelenting volley of personal attacks and interruptions.
In the weeks ahead, you can expect to see even more headlines predicting the election outcome, and how stocks will react.
Some analysts see banks and oil companies benefiting from a Trump presidency, while a Biden administration will likely boost green energy projects. To forecast the election results, political pundits have turned to stocks and even prediction markets.
Judge for yourself how accurate these predictions turn out to be, but remember, adjusting portfolios to who you think will win the White House is likely to be ill-advised.
Can the stock market really predict the election?
Since 1928, stock market performance during the three-month stretch before a US presidential election has correctly predicted the outcome 87% of the time. This data point comes from US brokerage firm LPL Financial.
The incumbent party usually wins when the S&P 500 delivers positive returns in the three months leading up to the election. But when stocks are lower during that period, the opposition party usually wins.
This indicator correctly predicted Hillary Clinton’s loss in 2016, despite most polls favouring her to win. But right now, signals are mixed. Stocks surged to an all-time high in August but corrected course in the early weeks of September. No one knows which direction the stock market will take in the coming weeks.
Whichever way the market swings, bear in mind that the upcoming election is taking place in the midst of a rare, unexpected global pandemic. The stock market’s performance may not be as reliable an indicator this time round. It all boils down to whether voters will lay the blame for the economic and stock market downturn on Donald Trump.
How accurate are prediction markets in foretelling the election?
The predictions of a large group of people are usually more accurate than that of any individual. A well-known example of this comes from a “guess the weight of the ox” competition held in Plymouth back in 1907. The average weight guessed by the 787 participants was 1,197 pounds – just one pound less than the ox’s true weight.
This is the basis of modern day prediction markets. Prediction markets are simply financial markets where people can buy and sell shares in predictions. Over the long term, they have shown to be better predictors of election outcomes.
For the US election, prediction markets may trade a “Trump stock” that pays out $1 if Trump wins, and $0 if he loses. These “stocks” for Donald Trump and Joe Biden are priced between $0 and $1. So, if the Trump stock trades at $0.45, then the market thinks that Trump has a 45% chance of winning.
A commonly cited proof that prediction markets are accurate is this statistic from the Iowa Electronic Markets (IEM), set up for the 1988 presidential elections.
In the week before presidential elections from 1988 to 2000, IEM predictions were within 1.5 percentage points of the actual vote. Polls on the other hand, have an error rate of over 1.9 percentage points.
The caveat is that prediction markets are not always accurate. IEM and other online prediction markets got it wrong about the 2016 election outcome. They were also wrong about Brexit.
The election is not the only factor to consider
As interesting as all these predictions are, the upcoming election is not the only factor that could roil the markets. During the past months, markets have surged on the prospect of a fast-track coronavirus vaccine and further stimulus from governments and central banks.
However, the US Congress and Trump officials have been locked in a stalemate over more stimulus measures for several lengthy weeks. The Federal Reserve has pledged to keep interest rates at near to zero for the next three years, but there is a lack of clarity on what more they will do to help prop up investor confidence.
Adding to mounting uncertainty is the unease that the market has experienced too quick of a run-up. With much of the world still battling the pandemic, it is surprising that both the S&P 500 and the Dow notched their best August in more than 30 years last month.
Finally, as the northern hemisphere nears winter, the risks of a COVID-19 second wave are very real; and the timing of an effective vaccine uncertain. In the UK, new restrictions have been introduced to try to stop the spread of the virus. If other western countries are also forced to go into a second national lockdown to contain the virus, there may be long-term structural damage done to the global economy.
The role of easy liquidity in the stock market
Following a frothy August, stocks have recently tumbled with tech stocks leading the sell-off. This is quite a reversal from previous months where FAANG (Facebook, Apple, Amazon, Netflix, Google) propelled the S&P 500 to new highs.
It is worth noting that easy liquidity and low yields have been the main drivers of this historical rally. These factors are the direct consequence of the Fed slashing interest rates and expanding its asset purchase program to include corporate and municipal bonds.
And after a remarkable rally, it is normal and healthy for the market to pull back as market participants consolidate some gains. This is a natural part of the market cycle and investors should not be unduly swayed.
However, what investors should expect is further volatility ahead. The upcoming elections, the risks of a prolonged pandemic, the uncertainty about economic growth and the labour market will weigh on the market. Ultimately, a full economic recovery still hinges on the development of a successful, widely-available vaccine that will be accepted and used by most people.
Stay the course regardless of the election outcome
Given the myriad of factors that may influence the market’s direction, the question to ask yourself is whether it is wise to make any portfolio changes solely based on who becomes the 46th US president.
Who wins the White House is important, but the US Senate and Congress arguably hold greater influence over policy making. In an increasingly globalized world, events in other countries – not to mention a global pandemic – can also affect the US market. In other words, there are other factors that can have a far greater impact on stock prices than a Trump or Biden presidency.
The takeaway from all this is that you should stay the course with your investments. Stick with the plan you have built around your financial goals and risk appetite. The long-term reasons for choosing your portfolio should not change when 3 November comes along.
So take what you read in headlines with a grain of salt. And remember, over each president’s four-year term, the stock market has gone up and down any number of times. But over the long run, the stock market’s trajectory has always been upwards.