Would Kerry Help the Stock Market?

[Mr. Engen is a resident scholar at the American Enterprise Institute.]

In recent weeks, John Kerry and his supporters have claimed that his policies would stimulate the economy and that his election would be good for the stock market. Kerry supporters, for example, cite a Merrill Lynch study that shows that since 1943 the stock market returned 13.6% annually, on average, under Democratic presidents, compared with 11.7% under Republicans.

However, we do not need to speculate whether Sen. Kerry's election would provide a boost to the stock market. He has been the putative or actual nominee for many months. One can examine how his shifting political fortunes have affected the stock market itself. When Sen. Kerry's chances for election have risen in the short term has the stock market reacted positively as well? Unfortunately for the Democratic nominee, the answer is "No."

As a measure of Sen. Kerry's likelihood of election, data is used from the trading of real money future contracts based on election outcomes run by the Iowa Electronic Market. Academic research has shown that this market has been a very accurate predictor of elections -- better than large-scale polling services.

In the winner-take-all market, participants can buy and sell a security that pays $1 if their candidate wins. The price of a futures contract for Sen. Kerry or President Bush can be interpreted as market participants' current collective call on the standing of the election. On Aug. 9, for example, individuals could pay 51 cents for the contract that will pay a dollar if President Bush wins. This implies that the market believes there is about a 51% probability that Bush will win. Contracts in this winner-take-all market have been trading only since June 1, while closely-related futures contracts where the prices reflects the market's expectation of the share of the total vote received by each candidate have been trading since early in the year. A greater expected vote share would suggest a greater probability of the candidate actually winning the election.

The accompanying chart plots the trading price of futures contracts for Sen. Kerry's share of votes along with the value of the S&P 500 composite index since March 3, the day after the Super Tuesday primaries. When the expected vote share rises and thus the implied probability of Sen. Kerry winning the election increases, the S&P 500 index tends to decline sharply. The pattern is consistent and significant. Given the negative response of the stock market index to increases in his electoral prospects, this suggests that a Kerry victory, or its inevitability in the run-up to the election, could cause a significant stock market decline. The correlation is apparent even when the lackluster response to Sen. Kerry and the Democratic convention depressed the value of the Kerry futures contract, and the stock market simultaneously rallied....