The most important thing about the midterm elections is not who wins but simply that they are being held. Although studies linking market responses to presidential election surprises show that stocks respond well to Republican wins and bonds do well following Democratic victories, the magnitudes of the moves are small. GOP presidential wins boost stocks just 2 to 3 percent, on average, the day after the election.
What about partisan control of Congress? When I was head of the Washington research team at ISI Group, we looked at the performance of the Standard & Poor’s 500 index from October 1 of midterm election years through the following September 30. Gains were robust, averaging 25 percent, compared with an average of 9 percent for the rest of a presidential term. What was striking was that the gains seemed independent of the outcomes. In fact, the top three years all came after Democrats made big gains under Republican presidents, and two of those had Democrats replacing Republicans as the majority party in one or both chambers of Congress.
Taking a closer look at presidential-congressional combos shows that market performance is best under Democratic presidents and Republican Congresses. But there have been only eight years since 1945 featuring this mix, and six occurred between 1995 and 2000, during the tech stock bubble.
Why this partisan indifference? The time period we’re looking at includes a big part of the third year of a presidential term, and as students of the presidential cycle know, this is the most robust year for stocks. The argument goes that stocks do well in the third year in anticipation that incumbents will generate a good economy in their final year to maximize their reelection odds. I’ve always thought this notion worked better in practice than in theory.
Stocks often don’t generate partisan preferences, even over shorter periods. U.S. equities fell for a month after the GOP landslide in 1994 under Bill Clinton before rallying when the end of the Federal Reserve Board’s rate-hike cycle dominated the election results. In 2000, after the U.S. Supreme Court decision ended the presidential election uncertainty, stocks fell because the emerging recession trumped George W. Bush’s victory. Scott Brown’s January win in Massachusetts, which deprived Democrats of their Senate supermajority, produced just a one-day stock rally.
Though markets care about election outcomes, they are usually overwhelmed by other factors. For this election, the extent to which deleveraging dominates the economic data, and the Fed’s response to it, will tell the tale for the market. The election takes place November 2, and the Federal Open Market Committee meeting concludes the very next day. The Fed, not the composition of Congress, will be the policy driver for the market over the next year.
I’ve often found that elections matter more for sectors than for the overall market. Looking ahead to November, traditional energy companies may have the most at stake, as a Republican Congress would try to block funding for the Environmental Protection Agency’s efforts to regulate greenhouse gases. Health care companies would likely benefit, partly as a knee-jerk reaction to the prospect of Republican efforts to reverse health care reform. Financial stocks may also benefit in a similar knee-jerk fashion, but it’s unlikely that Republicans would make a material effort to roll back financial reforms.
The real impact of the midterm election on financial markets will come as a result of policy actions taken by Washington. That in turn will depend on a complicated game of chicken played by Democrats and Republicans as they choose which issues to confront each other on. Two recent presidents lost their congressional majorities — Clinton during his first term and Bush in his second. The former offers a better guide to President Obama’s choices, as first-termers have greater incentives to cooperate with an opposition Congress, hoping to show results in their reelection drives. After the aggressive tactics of the then-resurgent Republicans failed in 1995–’96, they reached agreement with Clinton on a series of secondary issues in mid-1996.
It’s not hard to see the two sides, faced with a weakening economy, agreeing on a payroll tax cut. But barring a genuine double-dip recession, it’s easier to contemplate stalemates on near-term stimulus and long-term deficit reduction issues. In fact, stalemate seems to be the order of the day on most issues. It’s worth thinking about what that might mean for the higher stakes in 2012.
Tom Gallagher recently joined Washington business advisory firm Scowcroft Group as a principal. Before that he led ISI Group’s Washington research team and ranked first in II’s All-America Research Team for the past eight years.
