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“Suddenly, nothing worries this stock market… VIX futures contracts for November and December receded sharply, reflecting less anxiety over a contested election result.”
– Barron’s (Oct 12, 2020)
“Gridlock Is good”
In a recent interview, I answered a question in an off-handed way, which I now regret. I was asked about the possible impact of a messy election on the market.
The public fears this sort of prospect, apparently.
Last year, a poll by Investors Business Daily (IBD)
At the top of the list was “gridlock in Washington.” (This was before Covid of course.)
Disarray in government, such as might be created or exacerbated by a contested vote, cannot be a good thing for the country, right? And since we know that what’s bad for the country is bad for General Motors
But IBD offered a knowing contradiction:
- “The truth is that they’re wrong. Gridlock is not a threat to the economy. If anything, at this point, it’s a potential blessing.”
“Gridlock is good” [GIG] is the belief that when the government is hamstrung, for whatever reason, it is not just OK, but positively positive for the stock market’s performance, even a “blessing.” The folk reasoning is that an incapacitated government is less likely to change the rules by passing new laws and regulations.
GIG is one of those contrarian financial tropes which is supposed to surprise you, a triumph of the market’s deeper wisdom over your mere common sense. If you google “gridlock and the market,” you’ll see link after link to articles and blogs, many from the mainstream media and renowned market experts, extolling the virtues of one form or another of government paralysis for stock market prospects.
- “The chief equity strategist at Bank of America Securities
BAC: ‘The stock market loves gridlock.’ … The chief investment strategist at Deutsche Bank Securities: ‘Gridlock has been very good for the stock market.’”
How silly of you to worry.
And so, why should a contested presidential election be any different? As a regular consumer of the conventional wisdom, I glibly repeated it when the question was posed: “Gridlock is good,” I said – and the reporter dutifully took it down. The opinion loop was closed.
Is Gridlock Really Good?
Later though, it nagged at me. The effect of the electoral calendar on the market is a topic I cover in my university course on pricing anomalies – there are many ways to parse it. But I felt somehow uncertain about the specific question. In a search of the academic literature, I found a study that looked at the effects of split government – that is, when one party controlled the executive branch and the other controlled the legislative branch, or the Senate and House are themselves divided – and the results were decisively the opposite of my GIG pronouncement.
The article starts off by standing up the standard punditry:
- “Business publications and financial market commentators frequently refer to a connection between security market returns in the United States and “political gridlock.” The conventional wisdom is that political gridlock, which exists when the U.S. House of Representatives, Senate, and presidency are not controlled by the same political party, is associated with favorable equity market performance. The press, political analysts, and financial analysts generally suggest that gridlock is good for the equity markets.”
Then they lowered the boom.
- “The results are strongly counter to the view that equity markets prosper during periods of political gridlock. Instead, we found that equities performed better during periods of harmony; more specifically, small-capitalization equities thrived during periods of political harmony.”
The “Harmony Premium,” which occurs when one party controls the Presidency and both branches of Congress, is decisive. These researchers conclude that GIG is “a myth.”
But — as with most “facts” in the field of Finance, different studies produce bafflingly different results. The Bank of America examined a longer period (1928-2018) and found that “the best average annual total return for the S&P 500 have followed the “gridlock” that comes when control of the two houses of Congress is split between Republicans and Democrats.” The analysis was defined in the exactly same way as the earlier study, with exactly the opposite result.
Indeed, 2018 was a good year for GIG. The stock market took off immediately after the 2018 midterms brought in divided government.
- “Stocks moved sharply higher Wednesday following midterm election results that gave Democrats control of the House but increased Republicans’ control over the Senate. The Dow soared nearly 550 points, a gain of 2.1%. The S&P 500 was also up 2.1% and the Nasdaq
NDAQsurged 2.6%. Stocks hit their highs of the day after Attorney General Jeff Sessions announced that he was resigning at the request of President Donald Trump. ‘Split control of government has traditionally been good for stocks, said [so-and-so]…’”
The Financial Times also weighed in to let us know that gridlock is just “fine.”
But wait – S&P Global’s chief investment strategist looked at an even longer period (1900-2011). Harmony prevailed once again. Hmmmm.
The Real Lesson: The Market Mutates
And so – the evidence on gridlock is “mixed.”
But is it really evidence? The real lesson here is to beware of statistics derived from small and unstable data sets. If we stand back from the numbers, and consider the ebb and flow of economic history over the last century – a boom in the 1920’s, a deep depression in the 1930’s, a war, a cold war, another boom, stagflation, the long bull market from 1982-2000, the dot-com crash, the 2008 crisis, and the second long bull market from 2009-2020… the pattern seems more episodic than statistically coherent, more about shifting market regimes rather than patterns of stable and invariant behavior suitable for these sorts of analyses.
Are there really comparable system dynamics – or “laws” of behavior, if you will – at work in the markets across this long stretch of human time? Can we suppose that the market of, say, 1912, or 1952, responded to “government gridlock” (however defined) in the same way as in 2020? There is a fascination in some corners of academic Finance in scouring very long time series to find patterns, regularities, indeed “laws” – but often this is a fallacy, once we consider the nature of both the “endogenous” changes within the financial market itself and the “exogenous” changes emanating from the political and economic systems in which it operates. Of the patterns of market behavior that dominated in the age of J. Pierpont Morgan – before the Federal Reserve existed, before the Income Tax existed, before the SEC existed, in the era of the gold standard and the Model T, when the epitome of technology was the ticker-tape – do we really expect to see the same dynamics in the era of JP Morgan Chase
The market mutates. That is, its behavior patterns change, sometimes abruptly, and irreversibly. Patterns in the market do not repeat. They evolve. One discovers that data-sets like these election time-series are quite pliable. A few cuts and slices, and the sample can be pushed around, to yield the desired result all too easily.
In short, the whole question of GIG or not-GIG may well be a red herring. Will a contested election in 2020 wreck the market? I’m not sure that any of the data from past experience can predict that outcome. The closest parallel we have was the Bush v Gore quandary in Nov/Dec 2000. Over 33 days of electoral uncertainty, the market traded more or less flat, and the VIX hardly moved. No alpha in evidence here. There was much political uncertainty. But the stock market remained calm.
The market is a funny creature. It is ultra-sensitive to some events, and impervious to others. Its sensitivities are often not the same as ours. What shocks and dismays us as human beings may not move the market much at all. The way it has shaken off the Covid shock would suggest that it may be ready to display a similar aplomb should the election present a disorderly scenario. As strange as that sounds, Chaos is probably already priced in.