Political Appeal

Story Highlights:

• Markets seemed to react poorly to the Obama administration's potential plan to convert the government's existing preferred shares in bailed-out banks to common stock.
• There's been plenty of scrutiny surrounding the still-young Obama administration, and perhaps rightly so—the administration's been active, and under its leadership, markets have been volatile.
• If Obama wants to be re-elected, he'll move toward the center to appeal to a wider constituency than his party base.
• When Democratic presidents learn this quickly, history shows markets perform very well the inaugural year. Historically, markets have posted double-digit positive growth (averaging +17.5%) under Democrats' first years.

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The government's bank stress tests may show some big banks fall short of capital requirements to cover potentially bad loans. But Congress is making noise about not wanting to provide additional bailout funds, so a new option was voiced this weekend—and perhaps was one reason behind Monday's Financials-led market drop.

The Obama administration signaled it may convert the government's existing preferred shares in bailed-out banks to common stock, should banks need additional capital. By a regulatory yardstick, every dollar converted from preferred to common shares becomes an additional dollar of capital. Thus, voila—more capital without additional government funds. But the solution isn't perfect: The common shares would give the government a large outright ownership stake and considerable voting rights in return—and could be viewed as a backdoor to nationalizing the banks.

This plan is far from concrete, however, and the government seems keen to assuage nationalization fears. There's been plenty of scrutiny surrounding the still-young Obama administration, and perhaps rightly so. The administration's been active, and under its leadership, markets have sharply sold off and then swiftly rebounded. Any way you view it, it's a lot of volatility.

Looking forward, what will likely be President Obama's impact on markets? The answer depends on whether Obama is a good student of presidential history or not. Strong partisans on either side can slice and dice historic data to argue their party is overall better for markets. However, calculated correctly, neither Democrats nor Republicans are as a whole much better for stocks. But there's a surprising party impact on markets during the election and inaugural years when presidential power switches between parties.

Preconceived thinking suggests Republicans tend to be pro-business (and thereby better for markets) and Democrats less so. During elections, presidential candidates make campaign promises appealing to their core party base. Republicans tend to have more pro-business rhetoric, while Democrats tend to be viewed as more business-unfriendly. Reacting to election rhetoric, markets historically do worse during election years when presidential power switches from Republican to Democrat (averaging -2.8%) and better when power switches from Democrat to Republican (averaging +13.2%).

But following the election, in the first year of their term, presidents know to win re-election they must garner independent and marginal opposition voters and deflect from their power base. The president's party base is already a bird in the hand—there's nowhere for those voters to turn. If presidents don't turn on their power base fast, their odds of getting re-elected diminish.

Markets expect a Republican president to be strongly pro-free market, but are disappointed when he is less so. And the reverse is true for Democrats when he's more market-friendly than markets expected. We see this impact in historic returns. Categorically, Republicans have miserable first years whereas Democrats have much better returns—averaging +17.5% and always double-digit positive, except Carter who was down just 7%. Note, Carter was a one-term president—could be he didn't turn on his power base fast enough.

Market reactions to the Obama administration have been volatile thus far and likely will be for some time. But if Obama aims for re-election, this year could be another typical year for markets under Democrats' first years—a positive force that could boost stock prices higher.