The Midterm Effect

It turns out political theater isn’t the only exciting aspect of midterm elections, there’s a strong effect on stocks as well. Historically, stocks have clocked positive returns 86.4% of the time in the Q4 featuring a midterm election and the subsequent Q1 and Q2 ^[1].

Contrary to what you might think, bruising politics and stocks can mix quite well. That is as long as nothing gets accomplished in the course of the shouting and finger-pointing. This seemingly counterintuitive phenomenon is due to the fact stocks love politicians for doing what they do best. Nothing.

MORE: Interested in market analysis for your portfolio? Our latest Stock Market Outlook looks at key stock market drivers including market, political, and economic factors. 

If you’ve followed the news the past couple of years, it’s no surprise to hear Congress disagrees on most things. There hasn’t been much major legislation passed since Republicans took control of the House of Representatives in 2010, giving America a split Congress and a Democratic President.

What’s So Great About Gridlock?

Political gridlock means Congress is unlikely to pass anything substantial. Major legislation has the potential to alter property rights, regulations and the distribution of labor and capital, all things that are negatives for stocks.

Stocks can rise on gridlock without being weighed down by political uncertainty. This serves as a nice tailwind when paired with strong fundamentals and improving sentiment.

What Happens Next?

Partisan rancor on both sides has run right up to and through this week’s elections. After the election, gridlock is poised to continue, featuring a Democratic president and a high probability of at least one Republican-controlled chamber of Congress. Stocks like gridlock and like knowing it’s here to stay for the next two years. This should lead to the post-midterm sweet spot.

Post-midterm results are overwhelmingly positive. As you can see below, markets are up well above average during the three quarters around and after midterms. Q4s and the following Q1 and Q2 in midterm-election years have registered positive returns 86.4% of the time. That specific frequency is a coincidence. But the reason why isn’t.

It appears politics is set to remain mostly hot noise, just the way markets like it.

^[1] Source: Global Financial Data, as of 5/10/2014, S&P 500 Total Return Index from 12/31/1925 to 12/31/2010.