Presidents, prices and P/Es

David MoonBlog

by David Moon

Last week’s column about the correlation between a president’s political party and stock returns during his term of office generated quite a bit of reader response. Most offered their explanation as to why the S&P 500 has historically performed much better when a Democrat was president.

One reader suggested that stocks perform better when a Democrat is president because Wall Street prefers Republicans. I hope this guy gets some help.

The most commonly suggested explanation is that the US economy is stronger under Democrat presidents.  That assumption is correct, but the conclusion doesn’t follow from it.

Since 1929, average annual GDP growth when a Democrat was president was 4.57 percent annually. Republican GDP was 2.78 percent. The economy has, on average, been stronger when Democrats were in the White House.

The problem in assuming that this GDP growth differential is responsible for higher stock returns during Democrat administrations is that stock prices and GDP growth are not coincident data series.  Annual changes in one do not predict or cause that year’s change in the other.

The best predictor of stock returns during a president’s term of office isn’t his political party, but rather the starting point from which we begin measuring.

If asked how much weight you’ve gained or loss, your answer would depend on whether you begin measuring from the day after Thanksgiving, immediately following a month-long fight with flu or since your birth.

Likewise, stock market gains or losses depends on the level of the index at the beginning of the measurement period.

The average price-to-earnings ratio at the beginning of each new presidential term of the S&P 500 since 1929 is 16. When a president’s term began with a P/E ratio higher than 16, the subsequent four-year annualized return was 6.4 percent, compared to 14.8 percent when the term began at a P/E less than 16.

The market has performed better when measured from a point of relatively low stock prices.

This observation leads to another question: is there some correlation between P/E ratio and a president’s political party?

The average P/E of the S&P 500 at the beginning of new Republican administrations has been 17.3, compared to a P/E of 15 when the office has shifted to a Democrat. The stock market should have performed better when a Democrat occupied the White House; they have generally come into power at times when stock prices were, relative to historic norms, low.

So why have Republicans come into office when P/E ratios are higher than average? And why have Democrats tended to come into office when P/E ratios were lower?

Simple: because stock returns have been higher when a Democrat has been president.

Which, of course, circuitously returns us to the original conclusion, effectively arguing that something is true because it is true.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).