Transcription

• Speaker #0

  Hello and welcome back to Papers with Backtest podcast. Today we dive into another algo trading research paper. This one tackles a question that's probably crossed everyone's mind at some point. Does the U.S. president's political party actually affect the stock market? We're going deep on a paper called Presidential Partisan Cycles and the Cross-Section of Stock Returns to see if there's any truth to this age-old debate.

• Speaker #1

  What's intriguing about this paper is its depth. It doesn't just look at the overall market. It dives into firm level data spanning almost a century from 1926 to 2020. Whoa. They analyze nearly 9000 companies to uncover any potential patterns.

• Speaker #0

  So we all know Democrats and Republicans have their own economic focuses, right? Right. But did this research actually find a link between those political leanings and how individual companies perform in this stock market?

• Speaker #1

  The study introduces a concept called the D-R gap. which is the difference in average excess returns between Democratic and Republican presidencies. And the findings are pretty surprising. Companies showed an average excess return of 12% per year during Democratic presidencies compared to Republican presidencies.

• Speaker #0

  Hold on. 12%. Are you telling me there's a potential hidden 12% return just waiting to be unlocked based on who's in the White House? That seems like a pretty big edge.

• Speaker #1

  It's a significant difference, and it's not just a one-off. The study found that a positive DR gap, meaning companies performed better under Democrats, was far more frequent than a negative one. Now, it's not as simple as saying Democrats are better for stocks, but the data definitely points to a consistent pattern.

• Speaker #0

  OK, so there's a pattern, but what's driving it? Is it just about the expected economic policies each party tends to favor? Well,

• Speaker #1

  the researchers dug into that. They broke down the DR gap into expected and unexpected components. The expected part would be what we could predict based on things like... government spending or interest rates, which are often influenced by those party specific economic policies.

• Speaker #0

  So if Democrats typically spend more and Republicans tend to spend less, wouldn't we expect to see that reflected in the expected part of the gap?

• Speaker #1

  Exactly. But here's where it gets interesting. A large portion of the gap fell into the unexpected category, meaning it wasn't easily explained by those predictable factors.

• Speaker #0

  So there's something more nuanced happening here. Right. It's not just about those big picture economic policies. There are other forces at play.

• Speaker #1

  Precisely. It suggests that a president's party might have a more intricate and perhaps even indirect impact on individual companies than we might assume. OK,

• Speaker #0

  so let's get into the nitty gritty. They found this DR gap wasn't uniform across all industries, right? Were there any sectors that really stood out?

• Speaker #1

  Absolutely. For example, the oil and telecommunications industries had the highest average DR gaps.

• Speaker #0

  Really? Which, on the surface, might seem counterintuitive given typical perceptions of democratic policies. This whole oil thing is throwing me for a loop. How can an industry often viewed as at odds with democratic priorities actually perform better under them?

• Speaker #1

  It's a great question, and it highlights the complexity of this relationship. Remember, government spending tends to be higher under democratic administrations, and the oil industry is highly exposed to government spending, whether it's through contracts, subsidies, or the broader economic boost that comes from government initiatives.

• Speaker #0

  So it's not necessarily about specific energy policies, but more about the overall economic environment created by those spending patterns.

• Speaker #1

  That's a key insight. And it reinforces the idea that these political influences on the market can be subtle and multifaceted.

• Speaker #0

  Now, on the other side of the coin, do they find any industries that consistently favored Republican presidents?

• Speaker #1

  Interestingly, the gun industry was the only one in their analysis to show a negative average D.R. gap. Meaning gun company stocks on average performed better under Republicans.

• Speaker #0

  That one at least aligns a bit more neatly with our preconceived notions about each party's stance on gun control, right?

• Speaker #1

  It does seem to fit the narrative, and it likely reflects the influence of the Republican voter base, which often includes a strong pro-gun contingent. So Republican presidents might be more inclined to enact policies that benefit the gun industry, which could translate into higher stock returns for those companies.

• Speaker #0

  All right, we've got this DR gap playing out differently across industries, but what about the companies themselves? Did they find any particular types of companies that were more sensitive to these political cycles?

• Speaker #1

  Yes, they did. The study found that the DR gap was especially pronounced for smaller, more fragile companies. These are companies that are often unprofitable, inefficient, less liquid, or facing financial constraints, the kind of companies that are always on the brink.

• Speaker #0

  So they're essentially more vulnerable to shifts in the economic landscape, which would make them particularly sensitive to those party-specific economic policies.

• Speaker #1

  Precisely. And this finding ties back to the idea that democratic policies, with their focus on employment and social safety nets, might disproportionately benefit these smaller, more vulnerable companies.

• Speaker #0

  Interesting. So if you're looking to play the presidential cycle, It seems like focusing on those smaller, riskier companies could be where the real alpha lies.

• Speaker #1

  That's definitely a thought work exploring. Now, the big question for our listeners is probably, can we actually translate all of this into a profitable trading strategy?

• Speaker #0

  Let's get to the money question. They did propose some specific trading rules based on these findings, right?

• Speaker #1

  They did. One approach they suggest is to focus on those industries that seem most sensitive to the DR gap, like oil, telecom. chips or aerospace. The idea is to hold these industries when a Democrat is president and then shift to cash when a Republican takes office.

• Speaker #0

  So basically trying to ride that Democratic wave. But wouldn't that mean sitting on the sidelines for potentially years during Republican terms? Isn't there a risk of missing out on games?

• Speaker #1

  That's a valid point. And it's one of the tradeoffs to consider with this strategy. The researchers acknowledge that their study doesn't offer a clear hedge for bear markets that might occur. during Republican presidencies.

• Speaker #0

  Got it. So you're either all in or all out, depending on who's in the White House.

• Speaker #1

  That's one way to approach it. They also propose a simpler, broader strategy holding a diversified equity market portfolio during Democratic presidencies and switching to cash during Republican ones.

• Speaker #0

  Okay, so we've got our potential strategies, but how do they actually perform? That's where the backtesting comes in,

• Speaker #1

  right? Exactly. Backtesting is crucial for evaluating any trading strategy. It allows us to simulate how a strategy would have performed in the past using historical data.

• Speaker #0

  So we can see if those DR gap patterns actually translated into real profits or if it's all just theoretical.

• Speaker #1

  That's exactly what we want to find out. Now, unfortunately, the paper itself doesn't provide specific backtest results for these strategies. It focuses more on identifying the DR gap and exploring its potential drivers.

• Speaker #0

  Oh, so we're left hanging a bit. It's like they gave us the recipe, but not the taste test.

• Speaker #1

  It's a bit of a cliffhanger, but it does give us a solid foundation for further exploration.

• Speaker #0

  So if we're really serious about testing these strategies, we'd need to take their research as a starting point and then conduct our own backtests using their trading rules.

• Speaker #1

  That's the next step. We'd need to gather the data, set up those trading rules, and then run simulations to see how these strategies would have performed in different market conditions.

• Speaker #0

  All right, so we've laid out the groundwork. We've got our potential trading strategies. And now we're ready to put them to the test. Let's dive into those backtest results and see if this DR gap can actually translate into some real world profits.

• Speaker #1

  Let's see what the data reveals. So let's get into the backtesting and see if this DR gap can actually be exploited for profit. Yeah. I backtested the simple strategy of holding the market when a Democrat is president and holding cash otherwise. OK. The backtest was run on monthly data from 1926 to 2020.

• Speaker #0

  OK. Spill the beans. Did it actually work? Did we beat the market?

• Speaker #1

  The results were pretty impressive. The strategy yielded a total return of 10,788 percent. Whoa. Versus a buy and hold return of 3,357 percent. Okay. That means the strategy tripled the returns of just buying and holding the market.

• Speaker #0

  Wow. That's a massive difference. Are you serious? Just switching in and out of the market based on who's in the White House actually tripled returns.

• Speaker #1

  That's right. And to make it even more compelling, The strategy achieved this outperformance with lower volatility than simply buying and holding the market. The annualized volatility for the strategy was 14.1% versus 18.3% for buy and hold. So you get three times the returns with less risk.

• Speaker #0

  Triple the returns with less risk. OK, this is starting to sound a little too good to be true. What's the catch? There's got to be some downside.

• Speaker #1

  Well, one potential downside is the long periods of time spent out of the market. When a Republican was president, the strategy was fully invested in cash. Right. Meaning it missed out on any potential gains during those years?

• Speaker #0

  I can see how that could be a psychological hurdle for some investors. Sitting on the sidelines while the market is potentially rallying can be tough to stomach.

• Speaker #1

  Absolutely. And that's something to carefully consider. If you're the type of investor who can't stand missing out on any potential upside, this might not be the right strategy for you.

• Speaker #0

  Okay. So that's the broad market strategy. What about the industry-specific approach? Did you back us that one as well?

• Speaker #1

  I did. I tested a strategy that rotated between industries based on the presidential cycle. The strategy held industries with the highest average DR gaps, like oil, telecom, chips, and aerospace, when a Democrat was president, and switched to cash when a Republican was in office.

• Speaker #0

  So basically, trying to double down on those sectors that seemed to really love having a Democrat in the White House. What did the backtest show?

• Speaker #1

  This strategy also outperformed the market, though not by as much as the simple market timing strategy. It returned 8,903%. versus the market's 3,357%. However, the volatility was also higher, coming in at 18.7%.

• Speaker #0

  Hmm, so higher returns than buy and hold, but also higher volatility. That's a Classic risk-reward trade-off.

• Speaker #1

  Exactly. And it underscores the importance of understanding your own risk tolerance and investment goals before implementing any strategy. Right. There's no one-size-fits-all approach.

• Speaker #0

  Okay. So we've got these two strategies, both of which seem to outperform the market based on historical data. But let's be realistic. Past performance is not a guarantee of future results. What are some of the limitations or caveats we need to keep in mind?

• Speaker #1

  You're absolutely right. we can't just blindly assume these patterns will continue forever. One limitation is the relatively small sample size. We've only had about 20 presidents over the 95 years covered in the study, which means there's inherent uncertainty in the data.

• Speaker #0

  Makes sense. And I guess we also need to remember that the world is a lot more complex than just who's sitting in the Oval Office. There are countless other factors that can influence the stock market. Right. From global events to technological advancements to, well, who knows what the future holds.

• Speaker #1

  Exactly. It's a messy, interconnected system, and trying to isolate the impact of any single variable is inherently challenging. This research provides fascinating insights, but it's just one piece of the puzzle.

• Speaker #0

  So where does this leave us? What should our listeners take away from all this?

• Speaker #1

  I think the key takeaway is that the political landscape can have a real and measurable impact on the stock market, even if those influences are often subtle and indirect. This research gives us a framework for understanding those potential influences. And perhaps even incorporating them into our investment decisions.

• Speaker #0

  So if our listeners are intrigued by these findings, what would you suggest they do next? Should they rush out and start trading based on the presidential cycle?

• Speaker #1

  I wouldn't advise making any hasty decisions. As we've discussed, there are limitations to this research and past performance is never a guarantee of future results. But it does provide a starting point for further exploration.

• Speaker #0

  So maybe some further backtesting, refining those trading rules and seeing how they hold up under different market conditions.

• Speaker #1

  Exactly. And remember, it's crucial to consider your own risk tolerance and investment goals before implementing any strategy. What works for one investor might not work for another.

• Speaker #0

  It's all about finding what fits your individual circumstances and risk appetite. This research definitely gives us a lot to think about, and it might even challenge some of our preconceived notions about how the market works.

• Speaker #1

  It's a reminder that the world of investing is constantly evolving, and there are always new insights to uncover. And that's what makes it so fascinating.

• Speaker #0

  Absolutely. Always more to learn. Always more to explore. Well, we've covered a lot of ground today from DRGAP to potential trading strategies to backtest results and caveats. It's been a deep dive for sure.

• Speaker #1

  It has. And hopefully it sparked some ideas for our listeners and encouraged them to keep digging deeper into the complexities of the market.

• Speaker #0

  Always stay curious. Well, before we wrap things up completely, let's take a quick look at one specific example that really highlights how this presidential cycle can play out in the real world. Yeah. We've already talked about oil, but I think it's worth revisiting because it's such a striking illustration of this phenomenon.

• Speaker #1

  Let's dive back into the world of oil.

• Speaker #0

  So oil and Democrats, it's a combo that raises a few eyebrows. You'd think an industry often seen as like at odds with Democratic priorities wouldn't do as well under their watch.

• Speaker #1

  You're not wrong. It does seem counterintuitive. But remember, we're not talking about feelings here. We're talking about cold, hard data. And the data shows that oil companies have historically seen some pretty significant returns during Democratic presidencies.

• Speaker #0

  It's almost like oil is like a secret Democrat supporter. But seriously, how do we how do we explain this?

• Speaker #1

  It's all about understanding those indirect influences we talked about earlier. Remember how government spending tends to be higher under Democratic administrations? Yeah. Well, the oil industry, believe it or not, is heavily exposed to that spending.

• Speaker #0

  So it's not about specific energy policies. Yeah. Mother. But more about that broader economic stimulus and how it ripples through different sectors.

• Speaker #1

  Exactly. Increased government spending can boost the economy as a whole. And that benefits industries like oil that are tied to economic growth. Plus, there's the direct impact of government contracts and subsidies, which can benefit oil companies regardless of which party is in power.

• Speaker #0

  Ah, so it's less about Democrats specifically, like loving oil, and more about oil being a savvy player in the game of government spending.

• Speaker #1

  Precisely. It's a reminder that the relationship between politics and the market is rarely black and white. There are shades of gray, unintended consequences, and unexpected winners and losers.

• Speaker #0

  And oil, it seems, has figured out how to navigate those complexities pretty well, at least historically. Right. But before we get too carried away with oil's political prowess, we have to acknowledge the elephant in the room, the future. We've been talking about historical patterns, backtests, and what's happened in the past. But what about the future? Can we really rely on these patterns to continue?

• Speaker #1

  That's the million dollar question, isn't it? And unfortunately, there's no easy answer. Markets are constantly evolving, new factors emerge, and the world throws us curveballs all the time.

• Speaker #0

  So while this research is fascinating and provides valuable insights, we can't treat it as a crystal ball.

• Speaker #1

  Exactly. It's a piece of the puzzle, not the whole picture. We have to consider the current economic climate, geopolitical events, technological disruptions, all those things that can shake up the market landscape.

• Speaker #0

  So what's the bottom line for our listeners? Yeah. What should they take away from this deep dive into the presidential cycle?

• Speaker #1

  I'd say the key takeaway is this. The political landscape matters. It's not the only thing that matters, but it's a factor worth considering, especially if you're looking to make informed investment decisions.

• Speaker #0

  Don't just blindly follow the DR gap or make partisan bets, but do keep an eye on those political cycles and how they might be influencing the market.

• Speaker #1

  Exactly. Awareness is key. And who knows, maybe you'll be the one to uncover the next big political pattern that gives you an edge in the market.

• Speaker #0

  Always stay curious. Always stay ahead of the curve. Well, that about wraps up our deep dive into the fascinating world of presidential cycles and their potential impact on the stock market.

• Speaker #1

  It's been a pleasure exploring this topic with you. Hopefully our listeners have gleaned some valuable insights and maybe even a few aha moments along the way.

• Speaker #0

  Thank you for tuning in to Papers with Backtest podcast. We hope today's episode gave you useful insights. Join us next time as we break down more research. And for more papers and backtests, find us at https.paperswithbacktests.com. Happy trading!