When politics trumps fundamentals
The Presidential elections are coming up soon and stock markets are increasingly going to be dominated by it. Lubos Pastor and Pietro Veronesi from the University of Chicago have shown that the uncertainty created by political events leads to market jitters and gives rise to a policy risk premium in stocks. And global policy uncertainty has been really high for a while now. Recent high levels in policy uncertainty have been driven by the trade war between the United States and China and of course the fiscal reaction to the Covid-19 pandemic.
The thing is that we all have only a limited attention span and when politics dominates the headlines, then company fundamentals are crowded out. As investors get distracted by politics, stock markets tend to show lower dispersion between stocks. All stocks, good or bad, tend to go in the same direction at the same time. Yosef Bonaparte from the University of Denver recently investigated stock market behaviour around US presidential elections and showed that this distraction leads to higher momentum effects once the election outcome is known. Because investors are distracted from fundamental company news and focus only on policy uncertainty, once the policy uncertainty is resolved, markets rally, independent of the underlying fundamental situation. This effect is quite strong. In the days in November after a general election (Presidential or mid-term) the momentum return to US stocks is 11.1% while for November days in other years it is a mere 1.4%. This momentum effect seems to take place independent of the political party winning the election. It seems to be simply a reflection of the collective sigh of relief of investors once political uncertainty recedes after an election. Once this relief rally has run its course, markets focus again on fundamentals, and momentum declines while dispersion between stocks increases.
Given the upcoming presidential election and the undoubtedly large distraction this election will provide this year, I am inclined to say that Bonaparte’s research will become quite relevant in November and open up an opportunity for some short-term profits in November.
Momentum returns after US elections
Source: Bonaparte (2019).