How do election uncertainties affect stock prices?

Q: I have read some commentaries in the news that the reason why the market has been falling lately was because investors are nervous that one presidential candidate who is currently leading in the surveys may win in next week’s elections? Is this possible? Please advise—Hope De Leon by e-mail

The stock market based on historical experience from the past four presidential elections has shown that it has always performed positively during the election year regardless of who wins the presidency.

Two months ago, I wrote in this column “How do presidential elections affect the stock market?” that the market tends to rise by an average of 5.9 percent from the start of the campaign period up to Election Day. When the campaign period has officially started, the market was at 6,637. If the law of averages were to be followed, the market must be trading at least at 7,028 level by next week.

So far, the market has already gained as much as 9.5 percent at 7,412 since the campaign period started and is currently entering correction mode. Following historical tendencies, the market should find some support near 7,000 level as election nears.

But could there be any possibility that current weakness in the market be attributed to a particular presidential candidate? Can a presidential candidate cause the market to fall because investors are jittery on how the new president will handle the economy?

If we are going to look at the historical patterns from the past elections, the market has always trended lower one week before Election Day. Three out of the past four presidential elections showed that the market has lost an average of 3.6 percent one week prior to elections. Such market behavior could not be due to any presidential personality but a normal market course as investors take a wait-and-see mode pending the outcome of the elections.

The market is expected to slow down during this period because investors are concerned on how credible the election process will be conducted. There are also many political uncertainties that can happen from Election Day up to the proclamation of the new President. This kind of uncertainties represents risks to the investor because it can affect market confidence, which may hurt stock prices later on.

Depending on how the events in the coming days will turn out, political uncertainties tend to raise the equity risk premium. When risk premium is high, the required rate of return on investments in stocks will also be high, which could depress share prices.

The easiest way to visualize this is by quantifying the risk premium. If the current market P/E at the moment is around 20x, simply reverse this P/E ratio to derive implied earnings yield of 5 percent. A 7-year government bond has an average yield of 3.5 percent. The difference of 1.3 percent is the risk premium, which investors normally demand as extra return for investing in riskier investments like stocks compared to risk-free government bonds.

Now imagine this risk premium increases by 1 percent due to heightened political uncertainties during the election period, the implied earnings yield will increase to 6 percent. Reversing this yield back to P/E will give ratio of 17x.  The resulting lower P/E target will mean share prices will have to fall by 15 percent from 20x P/E to 17x.

This could be the reason why historically the stock market tends to weaken during the month of presidential elections. For example, during the 1998 presidential elections, which Estrada won, the market fell by 7.8 percent by end of May. In the 2004 elections, which President Arroyo won, the market also fell by 2.4 percent. Again, in the 2010 elections that President Aquino won, the market also lost by 1.2 percent. For the last three presidential elections, the market has lost an average of 3.8 percent month-to-month.

Following the law of averages, the market may most likely lose this month and the index could go down to as low as 6,900 levels by end of May. As funds are expected to flow out during this decline, expect the peso-dollar exchange rates to be volatile, too. The volatility range from the past four presidential elections has an average of 4.8 percent. If the closing peso-dollar exchange rate at end of April was P46.60, the peso could depreciate to as much as P49 to a dollar.

If you are looking to invest, this may be a good opportunity for you to accumulate stocks at lower prices. History shows that the market tends to recover in the following month after all the worst of the election events have already been discounted. By this time, a clear winning presidential candidate is already known and many investors are already anticipating the market to go up.

Except for the 1998 elections where the market extended its losses after Estrada won due to a global financial crisis, all the past presidential elections showed the market recovering in June by an average of 5.4 percent. This rally hopefully will carry the market uptrend toward the year end.

Political uncertainty plays an important role in the market because it could negatively affect stock prices. Though the impact of this type of risk on stock prices is not fully diversifiable because it is beyond the control of the investor, the effect on the share prices may be temporary. The market will always recover once all the dust has settled.

Henry Ong is a Registered Financial Planner of RFP Philippines. Stock data and tools provided by Technistock. To learn more about stock analysis and value investing, attend the 8th Accredited Financial Analyst (AFA) program this June 4-July 9. To register, e-mail [email protected] or text <name><e-mail> <AFA> at 0917-9689774.