Review & Outlook

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Midterm elections and the market

12 October, 2010 by Ben O'Brien in Commentary

With the government’s vastly increased role in the economy since the financial crisis, investors will be watching the midterm elections closely.  What is going to happen and what does it mean for the market?

Everyone seems to agree that the Republicans will pick up seats in both houses in November, but the question is whether they will pick up the 39 seats required to take the House of Representatives or the 10 seats needed to take control of the Senate. Predictions among political experts vary widely, but many of the most respected pollsters are calling for a Republicans to take over the house. Few predict the GOP will take the Senate.

Whether or not the Republicans win enough seats to take control of either house, the midterm election is sure to increase political gridlock in Congress for the next two years. Even if the Republicans fail to take control of either house they will pick up seats and make it a lot harder for the Obama administration and the Democrats in Congress to pursue their agenda. On the other hand, if the Republicans win in a landslide, any sweeping changes are unlikely because of the presidential veto power.

What does this mean for the market? Whether increased gridlock will result in a period of benign neglect or else just an inability to address urgent problems is not clear. In the case of a Republican win, however, the perception that the GOP is friendly to business will likely set off a rally. Whether the Republicans can actually fix the nation’s economic problems is a more complicated question, but the hope that they will extend the Bush tax cuts, especially the capital gains and dividends tax should give a nice boost to the market in the short run.

A look at the market’s performance over the last 50-60 years confirms the hopes of a post election rally. Mark Hulbert of Market Watch pointed out in a recent column that the third year of the four year election cycle–the year after the midterm election–has produced an average gain of 24.7% since 1945. “The comparable returns for years one, two and four, in contrast, are 4.0%, 1.9%, and 3.3%, respectively.” This holds true regardless of which party comes to power in the election and whether there is more or less political gridlock after the election. It’s hard to explain why this is the case. One theory is that politicians intervene in the market in the first two years as they attempt to achieve sweeping ideological goals, but then step back and focus on getting reelected in the second two years of the presidential cycles, leaving the market to function on its own. Another study by Fidelity found a similar effect looking at the period from 1950-2009.