Now that the 2006 mid-term elections are finally over, the question on many minds is what will the results mean for the markets? The question can be answered to some degree by past history and two studies that show the stock market performs better and tends to be less volatile when Democrats are in power.

This discrepancy was explored recently in a study by two finance professors at the University of California at Los Angeles, Pedro Santa-Clara and Rossen Valkanov.
According to their paper, entitled, "The Presidential Puzzle: Political Cycles and the Stock Market" and published in the October issue of the Journal of Finance, stock market returns are on average about 5 percent higher when the White House is run by a Democrat than during Republican rule.

Looking at the 72-year period between 1927 and 1999, the study shows that a broad stock index, similar to the S&P 500, returned approximately 11 percent more a year on average under a Democratic president versus safer, three-month Treasurys. By comparison, the index only returned 2 percent more a year versus the T-bills when Republicans were in office.

The study also looked at how the index responded under both Democrats and Republicans, using two portfolios tracked by the Center for Research in Security Prices, a research outfit affiliated with the University of Chicago's business school.
The "value-weighted portfolio" ranks all the stocks in the index according to their total market value, whereas in the "equal-weighted portfolio" the stocks are all ranked the same. On average, value-weighted portfolios returned 9 percent more under Democrats than Republicans during the 72 year period, while equal-weighted portfolios returned 16 percent more under Democrats.

The study examined a variety of reasons that might have caused this discrepancy. One particularly interesting finding was that markets seemed to show more surprise in reaction to economic or stock-related decisions made by Democratic administrations. "It thus seems that the difference in realized returns can be attributed to the market being systematically positively surprised by Democratic policies," the professors wrote.
According to their study, the difference in stock returns becomes gradually obvious through the course of a presidency, rather than in the period immediately surrounding an election.

However, volatility is actually lower during Democratic presidencies, according to both the UCLA study and another recent study by two political science professors -- David Leblang of the University of Colorado and Bumba Mukherjee of Florida State University.

The study which tracks stock market returns since the first day the Dow Jones industrial average was calculated in 1896 through the fall of 2001 -- shows that market volatility decreases during Democratic administrations. The paper argues that the expectation that inflation rates will rise under left-wing presidential administrations does indeed have an impact on trading, as older studies have suggested, but in a different way than those studies proposed.

"Our model predicts that rational expectations for higher interest rates under left-wing administrations decreases demand for stocks among traders," the professors write. "This decrease in demand leads to a decline in stock price volatility not only during the incumbency of left-wing governments, but also when traders expect the left-wing party to win elections."

Alternately, the statistics also show that expectations of lower inflation under right wing administrations make the market more volatile. This is because traders increase their inflow of capital and investment into the stock market when they believe the interest-rate environment is more friendly for stocks. More money at work translates into more volatility in the markets.

The study showed this trend was consistent regardless of whether a right wing administration was in office or whether traders merely expected the Republican party to win the presidential election.

So don't despair, for we probably will see two years of "gridlock" in which case there should probably be little regulatory or legislative change to upset the markets. I imagine that monetary and fiscal policy under Bernanke's Fed and the Democratic House and Senate should tend to hold the economy on an even keel. Can't wait for the '08 election to hit the airwaves?