Stocks usually rise after midterms, especially if government is split – USA TODAY

“It’s the economy, stupid,” became then-Gov. Bill Clinton’s slogan in 1992, while campaigning against President George H. Bush. He was right then and he’s still right as the economy tops voters’ minds in this year’s midterm election.

But what midterm outcome do investors think can help the economy and boost the S&P 500 index? It turns out, the answer to that may be gridlock.  

On Nov. 8, all 435 seats in the U.S. House of Representatives will be up for grabs along with 35 Senate seats. Democrats control the House by 8 seats (220 to 212 with three vacancies). The U.S. Senate has 50 Republicans, 48 Democrats, two Independents who often vote with Democrats and Vice President Kamala Harris, a Democrat, as the tie-breaking vote. 

Most economists, and pollsters, expect Republicans to regain control of the Housebut the Senate remains a coin toss.If Republicans win control of just one congressional body, this should prevent material policy changes for the next two years, they say. 

And that political gridlock has “historically benefitted equity investors, with the S&P 500 Index averaging annual gains within the range of 13.0%,” John Lynch, Comerica Wealth Management’s chief investment officer, wrote in a report. “Though counterintuitive, equity markets tend to prefer divided government.” 

The S&P 500 is considered a barometer of overall stock market performance because it includes 500 of the largest U.S. companies across industries.

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What do midterm elections mean? 

Midterm elections are often seen as a referendum on the sitting president and the economy, which have lately seen approval ratings near 40%, according to Reuters/Ipsos tracking. 

As voters go to the polls, they may recall the economy started 2021 strong when President Joe Biden took office, benefitting from COVID-19 vaccines that allowed economies to reopen more fully and boosted by the quickly approved and economy-accelerating American Rescue Plan Act.  

Since then, the economy has deteriorated. Payroll growth is slowing and notably, inflation has surged to the highest level in a generation. Major stock indices have fallen into bear markets, or at least 20% below their peaks, and the Federal Reserve has started aggressively raising interest rates to try to tame inflation. Meanwhile, low energy fuels stockpiles have analysts warning of higher winter heating bills.  

This plunge in the economy is why pundits are forecasting a strong showing for Republican candidates in November. 

Voters cast their ballots on Sept. 23 in Minneapolis. The upcoming midterm elections could give the stock market a sorely needed boost by eliminating at least some of the uncertainty that's clouding the way for investors.

What does history tell us about midterm elections and the stock market? 

Most data point to an upturn in the S&P 500 after the midterm elections. 

  • Since 1950, the average return for the S&P 500 in the 12 months after a midterm election is 15%, surprisingly with no down years, Lynch says. 
  • In 17 of the 19 midterms since 1946, stocks performed better in the six months following the election than they did in the six months leading up to it, Liz Ann Sonders, Schwab’s chief investment strategist, said. 
  • And if the outcome this year is as expected with a Democratic president and either a divided Congress or a Republican sweep of both chambers, equity investors should benefit with the S&P 500 averaging annual gains within the range of 13.0%, he said. 

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Does this mean we can bet on a stock market rally after the election? 

No. 

This year’s market performance has already diverged significantly from the average midterm election year, Sonders noted. 

“Post-election outperformance is often driven by the market’s expectation of increased government spending from a new Congress,” she said. “But an additional infusion of funds seems unlikely this year, given the government’s historic levels of spending and stimulus in response to the pandemic.” 

Some economists attribute the massive government spending over the past two years as contributing to 40-year high inflation, and any new spending could further exacerbate it. 

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“The combination of high inflation, the war in Ukraine, and a lingering pandemic has already made this cycle unlike prior midterm years,” she said. “With so many other forces at play in the market, I wouldn’t put much weight in historical midterm-year performance.” 

What we can expect more of though, Lynch says, is volatility. 

What should investors watch for stock market direction? 

The basics: inflation and Fed policy. 

“Despite the current headlines around the election and fiscal policy, we expect markets will maintain focus on monetary policy, as the Federal Reserve raises interest rates to defeat inflation,” Lynch said.  

With annual inflation still so elevated at 8.2% in September, he expects the Fed to work on getting that down closer to its goal of around 2% at the expense of employment and economic growth over the near term. 

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Can Democrats win the Senate and House?

James Knightley, ING chief international economist, pegs those odds at 10% and bad for stocks. 

“Markets would perceive this as being the lower growth and heightened political meddling outcome, which would tend to present a downside risk for equity markets,” he said.  

“The administration would have more power to meet a recession with a fiscal response,” Knightley said. “This would potentially make more difficult the Fed’s objective of bringing inflation back to 2%.” 

If Democrats keep the Senate, Lynch said infrastructure, hospitals and Medicaid HMOs, clean energy, utilities and municipal bonds investments might benefit. 

If Republicans sweep Congress, energy, defense, pharmaceuticals and biotech would be positioned favorably, he said. 

Medora Lee is a money, markets, and personal finance reporter at USA TODAY. You can reach her at mjlee@usatoday.com and subscribe to our free Daily Money newsletter for personal finance tips and business news every Monday through Friday morning.