Which presidential candidate is the stock market looking for?

For months the S&P 500 rose this year – despite a deadly pandemic, the resulting economic devastation and the rise of a Democratic Party increasingly sympathetic to democratic socialism. Then, last month, with Joe Biden doing well in the polls, stock prices finally stumbled.

It polls continue to point to a Biden victory in the 2020 presidential election, pandits will be tempted to see any further tremors in the stock market as expressing a concern about the economic priorities of a Democratic president. But the idea that the market favors a particular candidate or party, though widespread, is wrong.

Our research, which reaches back to the 1860s, when the two-party political system began to dominate, shows that the market has no clear bias in favor of either party and that market volatility in the run-up to an election is perfectly normal.

The market is an economic barometer, not a political one. To be sure, its collective mind pays attention to presidential politics, but as just one of many factors that can influence the direction of the economy. The leader that the market listens to most carefully is the head of the Federal Reserve, not the president. When states started imposing lockdowns in March, the market suffered a drastic crash, but then the Fed and the Treasury rushed in with promises of trillions of dollars to keep businesses afloat, and the market bounced back.

Last month’s market tremors are best explained by growing concern about Congress’s failure to pass a new spending bill and about the prospect of a contested election- not the prospect that Mr. Biden might win.

Indeed, the market seems to like a fresh face in the White House. Since the late 1860s, nine presidents have been elected to consecutive terms and have served at least five years. Eight of them saw higher market returns in their first term than in their second, often much higher. Ronald Reagan was the exception. First – term returns averaged 83%, second – term returns just 28%.

This finding is consistent with research on the “second-term curse”, which shows that underlying economic conditions tend to decline in a president’s second term. Likewise, there have been 16 elections since 1869 in which an incumbent finished a full term, and was fighting for a second. In general the markets do much better after an incumbent loses.

It’s worth noting that underlying economic conditions, including G.D.P. growth and inflation, have tended to be more favorable under Democratic presidents, which can make it seem as if markets prefer a Democrat in the White House. Since 1869, the average market return over the course of a full presidential term was 68% under a Democratic president compared to 52% under a Republican.

But the connection between economic health and a Democrat in the White House is largely coincidental. Politicians can influence but not control the business cycle. Economic factors, not partisan bias, provide the best explanation for why markets have performed better under Democrats.

Another clear pattern, based on data going back to the 1920s, is that markets grow more volatile in the three months before an elections. Whatever upset the market in recent weeks, the volatility started right on time historically speaking.

All of this casts doubt on the widespread assumption that Wall Street is rooting for a Trump win. The related notion, that Wall Street is rooting against a Biden win because of his party’s leftward drift, also does not jibe with what many leading investors are saying and writing.

These investors believe that despite Mr. Biden’s left – leaning campaign rhetoric, he will govern more moderately when in office, raising taxes and regulation while decreasing tensions over immigration, global trade and China. That mix would have some effect on which economic sectors do best during a Biden presidency, but little effect in our opinion on the market’s overall direction.

More important, the market cares less about who leads the free world than who leads the Fed. Low interest rates make stock look more attractive, so the Fed’s policies in recent years have been turbocharging stock prices. The U.S. stock market is currently more expensive than at anytime other than the dot-com bubble of 1999 to 2000, according to some measures.

What happens next in the market depends mainly on the direction of the economy and on interest rates. If over the coming months the economy keeps recovering but long-term interest rates start to rise rapidly, the market in our opinion could actually decline – a mirror image of this year’s market boom and economic bust. Many traders, eager to see the market rally continue, are arguing that if Mr. Biden wins he will bring in leadership at the Fed that will be even more aggressive about keeping interest rates low. That’s another reason Wall Street isn’t too worried about who will be the next president, and more than anything else just wants the election to be over.