With Election Season Heating Up, How Much Volatility Should We Prepare For?

As we head into October, with a contentious election less than five weeks away, it’s easy to see why investors are worried about what might be next. Expectations of volatility, as measured in the options markets, have spiked for November but questions remain. How big a drop might we see in financial markets? Will it be like 2000? Could it be worse?

From a political standpoint, unless there is a blowout win by one side or the other, we are almost certain to get litigation and an unresolved election. In the absence of a clear-cut winner, the question about how might markets react becomes a more pointed one. And once we do have certainty, what comes next?

“Dewey Defeats Truman” and the Hanging Chad

Since World War II, there have been two notable election surprises. The first, in 1948, was the famous “Dewey Defeats Truman” election, when Thomas Dewey most certainly did not defeat the incumbent Harry Truman. Dewey was considered the more friendly candidate to Wall Street, and in the aftermath of confirmation of Truman’s reelection, the stock market dropped 10% in one week. However, according to Forbes, the stock market went on to gain 128.4% during Truman’s second term.

More recently, many of us remember the “hanging chad” controversy surrounding the 2000 election. I have a vivid memory of my second ever AFM holiday party, at Alex’s house in Georgetown, where we all huddled around the TV to hear news of the Supreme Court’s ruling. Being 22 at the time, I mostly hoped they would get on with it, so that I could watch the Maryland – Florida basketball game that night (Maryland upset #1 Florida on a buzzer beater).

From Election Day to the Supreme Court ruling on December 12th, the market dropped 4%. The market then continued to drop for another week, before leveling out, with the total decline coming to roughly 12%. The market then struggled during Bush’s first term, as the tech bubble burst and then in short order the nation grappled with the aftermath of the 9/11 attacks.

Markets Usually Go Up in Election Years—and Afterwards

For each side, worries abound that a victory by the other will sink the markets. Could there be a prolonged downturn if one or the other wins? What does history tell us?

When we look back over time, in 14 of the past 17 election years, the S&P 500 was up in an election year. The exceptions? The year the tech bubble burst and the year of the global financial crisis. Elections, in and of themselves, do not seem to disrupt markets. We have seen that so far this year.

In the year following an election, the picture is similar. Eight of the last nine post-election years have shown gains, with six years of returns in the double digits. Even as we have seen gains in election years, we have seen further gains in the following year once the uncertainties around the election were resolved.

So, what does this tell us? We might see markets drop in November. Even if we do, though, over time they will come back. In the long run, it’s the fundamentals—consumer confidence and spending, employment, business investment—that play a stronger role in market performance.

What Should Investors Do to Prepare for Volatility?

As an investor, you should be aware of the potential short-term effects of the election. But that doesn’t mean you need to take action. Short-term fluctuations are the concern of traders, not long-term investors. If you have cash needs in the next six to twelve months, especially larger expenses, the money should be set aside now. By taking care of those needs now you can tune out the noise (or at least turn it down…) and avoid selling during a short-term decline.

What If There’s a Longer-Term Decline?

The real question here, for investors, is if we do see a decline, will it be short-lived or long-lived? Short-lived, we shouldn’t care. Long-lived? Maybe we should.

It’s certainly possible that we could get a longer-term decline. Looking at history, however, we probably won’t. Every time the market has dropped in a meaningful way, it has bounced back. Over time, markets respond to the growth of the U.S. economy, and if the economy keeps growing, so will the market. Unless the election chaos slows or stops the growth of the U.S. economy over a period of years, it should not derail the market over the long term.

Could the election do just that? It’s doubtful. We could—and very likely will—see a disputed election result. But there are processes in place to resolve that dispute. One way or another, we will have a resolution by Inauguration Day. While we will have a government in place, we will also almost certainly have continued political conflict, but this should not disrupt the economy and markets any more than we are already seeing.

Does the Market Care Who Wins?

Ultimately, not that much. Over time, the markets tend to go up.

One worry is that a Democrat administration will bring higher taxes that sink the market. History doesn’t bear that out. Since 1900, according to Bespoke Research, the average Republican administration has seen gains of 3.5% per year, while the Democrats have experienced gains of almost twice as much, at 6.7% per year. According to Legg Mason, since 1937 the market has posted a gain in 63 out of 83 calendar years – 76% of the time. Quite simply, the market goes up under both parties.

It does even better under divided government. The next president will likely have to deal with just that, limiting the administration’s ability to pass any significant legislation. The chart below from American Funds illustrates that at least when it comes to markets, gridlock has been good. And when put in this context, fears about the election’s effect on the market look to be overstated.

So, What Should Investors Do?

However appealing it may seem, as good citizens we can’t entirely tune out the election news cycle. But as investors, we don’t need to do anything with respect to our long-term plans. Like any specific event, however damaging, the election will pass, just as others have. We will get through this, although the next few months may be rocky. If you’re concerned about your portfolio, have cash needs on the horizon, or just want to talk, please contact us to schedule a phone or video call.

Authored by Brad McMillan, CFA®, CAIA, MAI, managing principal, chief investment officer, at Commonwealth Financial Network®.