Tuesday, September 28, 2004

The Stock Market and Political Cycles by John Nofsinger

Our tour of FMA papers continues with The Stock Market and Political Cycles by John Nofsinger.

John Nofsinger examines the historic relationship between who in office and how the stock market does. Contrary to previous papers that used data that went back to only to 1927, Nofsinger reports that for a longer time period (back to 1828!) "The full time-series history reveals that stock market returns are not different between the two political parties"

Talk about a timely paper! It is nearly impossible to watch TV without election coverage inundating you. Moreover many of you undoubtedly have been asked what does one party's candidate mean for the stock market. This speculation has been a hot topic on TV and in the popular press. For example: Business Week, Smart Money, The Baltimore Sun, CNN, and many others have done stories on what the presidential election means for the Stock Market.

The problem with many of these articles is that they are based more on opinion and short data sets (for example, the stock market was up when Clinton was president, therefore Democrats must be good for the stock market).

In academia the tie between presidential election and stock returns has also been looked at. While the data sets are bigger (generally from 1927 on), and the analysis more thorough, the findings are still quite mixed. For instance Santa-Clara and Valkanov report in a recent Journal of Finance article that the stock market does better when a Democrat is president than when a Republican is in office. This can be contrasted with Riley and Luksetich (1980) who find that the market rises on the news of a Republican victory.

Nofsinger examines this apparent contradiction by going back further in time. Using monthly stock data from 1802 (WOW--how cool is that?!! Jefferson was president!), and election data from 1828, he finds no apparent difference in stock market returns based on which party "owns" the White House.

In addition to this important finding Nofsinger proposes an important relationship that may exist. This "social mood theory suggests that the mood of the nation is reflected in the...stock market." (Is anyone else thinking of Charoenrook's Does Sentiment Matter?)

In Nofsinger's own words:
"As an alternative to the political policy theory, I propose that the performance of the stock market is a predictor of who will be elected president. When social mood is optimistic, the stock market is high and voters are content to reelect the incumbents. When social mood is pessimistic, the market is low and voters vote out the incumbent party. Therefore, this social mood theory suggests that stock market performance influences who wins the presidency...."

And later in the paper:
"In the social mood theory, I propose that people suffer from a misattribution bias (see Hirshleifer (2001)) when voting for president. That is, they miss attribute the source of their mood to the incumbent presidential party. They credit the incumbent party for their positive or optimistic mood and blame incumbents for a negative or pessimistic mood."

As such, "stock market returns are more likely to predict presidential elections than elections are to predict the stock market." (p. 1) Specifically, Nofsinger finds that the the return in the 3 years (36 months) prior to the election is a good predictor of whether the incumbent or challenger will win the election.

All in all a fascinating article and one that will definitely makes great conversation at many conference "sessions." (You can also read 'session' as party, social etc. ;) )

BTW the paper is also full of some cool facts such as equity ownership was less than 2% at turn of 20th century as opposed to about 50% now.
So read it! :)

1 comment:

stockexpert said...

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3 Steps To Profitable Stock Picking

Stock picking is a very complicated process and investors have different approaches. However, it is wise to follow general steps to minimize the risk of the investments. This article will outline these basic steps for picking high performance stocks.

Step 1. Decide on the time frame and the general strategy of the investment. This step is very important because it will dictate the type of stocks you buy.

Suppose you decide to be a long term investor, you would want to find stocks that have sustainable competitive advantages along with stable growth. The key for finding these stocks is by looking at the historical performance of each stock over the past decades and do a simple business S.W.O.T. (Strength-weakness-opportunity-threat) analysis on the company.

If you decide to be a short term investor, you would like to adhere to one of the following strategies:

a. Momentum Trading. This strategy is to look for stocks that increase in both price and volume over the recent past. Most technical analyses support this trading strategy. My advice on this strategy is to look for stocks that have demonstrated stable and smooth rises in their prices. The idea is that when the stocks are not volatile, you can simply ride the up-trend until the trend breaks.

b. Contrarian Strategy. This strategy is to look for over-reactions in the stock market. Researches show that stock market is not always efficient, which means prices do not always accurately represent the values of the stocks. When a company announces a bad news, people panic and price often drops below the stock's fair value. To decide whether a stock over-reacted to a news, you should look at the possibility of recovery from the impact of the bad news. For example, if the stock drops 20% after the company loses a legal case that has no permanent damage to the business's brand and product, you can be confident that the market over-reacted. My advice on this strategy is to find a list of stocks that have recent drops in prices, analyze the potential for a reversal (through candlestick analysis). If the stocks demonstrate candlestick reversal patterns, I will go through the recent news to analyze the causes of the recent price drops to determine the existence of over-sold opportunities.

Step 2. Conduct researches that give you a selection of stocks that is consistent to your investment time frame and strategy. There are numerous stock screeners on the web that can help you find stocks according to your needs.

Step 3. Once you have a list of stocks to buy, you would need to diversify them in a way that gives the greatest reward/risk ratio (The Sharpe Ratio). One way to do this is conduct a Markowitz analysis for your portfolio. The analysis is from the Modern Portfolio Theory and will give you the proportions of money you should allocate to each stock. This step is crucial because diversification is one of the free-lunches in the investment world.

These three steps should get you started in your quest to consistently make money in the stock market. They will deepen your knowledge about the financial markets, and would provide a sense of confidence that helps you to make better trading decisions.

About the Author: Zheng Fang is the creator of Advance Stock Pattern Scanner of www.cisiova.com and the owner of several stock picking blogs:

1. Optimal Portfolio
2. Candlestick Stock Picks
3. Cup and Handle Stock Picks
4. Technical Analysis