For Stocks, the Midterms May Not Matter. Here's Why That's A Good Thing.

Investors can find plenty to stress about as voters try to pick congressional candidates they believe will best help the nation navigate through inflation, labor shortages, a possible recession, international conflicts and divisive social issues. Here's one bit of reassurance: If history is any guide, at least you don't have to worry too much about the election's impact on your stock portfolio.

Since 1939, no matter which party has gained control of Congress, the stock market has risen in the year following a midterm election, according to a US Bank analysis. And though the market's post-midterm performance has varied widely over the years, on average, the outperformance in the modern era has been significant – especially in the first six months after election day. For the six months starting Nov. 1 of each midterm election year going back to 1962, the S&P 500 Index has returned a far-above-average 15%, US Bank found. The same periods during non-midterm years saw returns averaging just 4%.

Of course, past performance is no guarantee of anything. But many veteran stock analysts say that the midterm effect is a much stronger and more reliable trend than other, better-known stock market patterns, such as the "Santa Claus rallies" that tend to run from late December through early January, or rules of thumb including "Sell in May and go away" that single out seasonally strong periods. 

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"The midterm effect is one of most surprising and compelling patterns I have ever seen," says Jeff Buchbinder, chief equity strategist for LPL Financial. "It is very powerful because we go from an environment of political uncertainty to certainty."

Investors certainly appear to be uncertain during this campaign period. In August, the so-called fear index (the Chicago Board Options Exchange's Volatility Index, or VIX, which reflects investors' expectations of stock market volatility over the next month) was hovering more than 50% above the levels seen during the same periods prior to the midterm elections in 2014 and 2018. 

A Surfeit of Uncertainty

Another historical rule of thumb says that the president's party tends to lose seats in Congress in midterm elections: Since 1974, the president's party has lost an average of 23 seats in the House of Representatives, according to analytics and advisory firm Gallup, so history suggests a high likelihood that Republicans will flip at least the five seats needed to win a majority in the House.

One possible reason for elevated uncertainty this year: Many poll watchers say that this midterm is hard to predict because of a rapidly changing economy, controversies over Supreme Court decisions and investigations into former President Donald Trump. 

Democrats have outperformed expectations – including winning seats in two Republican-leaning districts – in the five special elections that have taken place since the Supreme Court upheld the right of states to ban abortion, according to polling website FiveThirtyEight. As things stood in early September, the oddsmakers said the most likely election result would be a split Congress – probably a Republican House and Democratic Senate. 

The good news is that over the past 60 years, investors have seen post-midterm gains under any political configuration. According to the US Bank data, since 1962, the stock market has gained 14% in the year after midterms that resulted in a Democratic president facing a split or Republican Congress. That's below the 17% gain after elections that resulted in full Democratic control, but beats the market turmoil so far in 2022.

Red or Blue Portfolio?

If the Democrats pull an upset and maintain control of Congress, watch for them to pursue incremental advances toward longtime goals such as further caps on healthcare or drug prices, additional green-energy initiatives, and a tax hike for multinational companies, says Rob Haworth, senior investment strategy director for US Bank Wealth Management.

That agenda could boost smaller, domestically focused companies and alternative-energy producers in particular. But Monica Guerra, U.S. policy strategist for Morgan Stanley Wealth Management, says the overall stock market has generally risen strongly in a fully Democratic Washington "because of a tendency to pursue initiatives structured to create tailwinds for consumer confidence [and] spending."

A divided or fully Republican Congress would cause some legislative gridlock and shift Congress's attention to issues such as protecting U.S. trade, supporting domestic technology producers and cracking down on Chinese stocks listed on the U.S. markets, says Edward Mills, Washington policy analyst for Raymond James & Associates. "Tensions between the U.S. and China will be accelerated if the Republicans win," he says. He also expects Republicans to try to follow up on promises to put the brakes on an increasing focus by corporations and investors on environmental, social and governance issues.

Given the uncertain political climate, as well as the growing unreliability of voter polls, it's risky to make big portfolio bets on specific sectors or types of companies that might benefit from particular outcomes of the coming election. Morgan Stanley's Guerra highlights sectors that could gain bipartisan support. She thinks both parties could come together to approve additional funding for defense, cybersecurity, energy independence and encouragement of domestic industry. That's bullish for defense contractors, makers of computer chips and green-energy companies.

But the safest bet is to stick with a broad market index, says Jędrzej Białkowski, a finance professor at the University of Canterbury in Christchurch, New Zealand. In a recent paper examining the post-midterm returns of U.S. stocks starting in 1954, he and coauthors Warwick W. Anderson and Moritz Wagner found that the rallies have been so broad that there has been no consistent underperformance or overperformance among sectors or investing styles. "The important conclusion for investors who would like to gain on the midterm effect is to invest in the broad market, not more-selective portfolios," he says. In other words, when it comes to preparing your portfolio for this year's midterms, you don't have to choose. You can vote with your dollars for "all of the above."