Midterm Elections and Markets

Summary Points

• Because the financial markets prefer unity, stock market returns have been the highest when the same political party controlled both houses of Congress.
• Historically, stock market returns have been strong during the third year of a president's term.
• Standard & Poor's Economics believes that Republican inroads in Congress increase the chances that the tax rates enacted under President George W. Bush could be extended.

The midterm elections of 2010 saw the tables turn in Washington, with Republicans reclaiming control of the House and gaining ground, but not dominance, in the Senate. What do the election results potentially mean for investors? Although the third year of a president's first term in office historically has been positive for the stock market, Sam Stovall, Chief Investment Strategist, Standard & Poor's Equity Research, pointed out that a split Congress and the resulting uncertainty could set the stage for more muted returns.

Q: Typically, how has the stock market reacted when no single party has dominated events in Washington?

A: It's important to understand that there have been only eight instances, out of 66 calendar years, since 1945 when the House and the Senate were controlled by different political parties; so the number of years to review is not extensive. That said, all of these instances, which I have called Total Gridlock, occurred under Republican presidents. The average gain in the S&P 500 under Total Gridlock was 3.5% compared with 8.4% for all periods. The rationale behind this subpar performance could be that gridlock generated uncertainty, and Wall Street hates uncertainty.

Historically, Total Unity, in which majorities of both houses of Congress share the same political affiliation as the president, has resulted in stronger periods for the equity markets. This scenario appears logical. Under a unified party government, if the president proposes legislation, it will likely be rubber-stamped by Congress, thereby stimulating the economy, increasing output, raising corporate earnings and propelling shares higher.

S&P 500 Percentage Changes During Presidential/Congressional Unity and Gridlock Since 1945

Source: Standard & Poor's Equity Research.

Q: What about the third year of a president's term in office? What does history reveal about trends during this period?

A: Since World War II, during the third year of a president's term, the S&P 500 has gained an average 17% and has increased 94% of the time. As the party in power attempts to retain its edge, Congress may be more likely to introduce economic stimulus designed to increase employment, send the stock market higher and influence voters to cast ballots favoring the incumbent political party during the next election.

Whether 2011 will be a typical third-year scenario remains to be seen. The federal government already has initiated a significant amount of stimulus with the Troubled Asset Relief Program (TARP) and two rounds of quantitative easing from the Federal Reserve. What else could Congress do? S&P Economics believes Republican inroads increase the chances that the tax rates enacted under former President George W. Bush could be extended for everyone, not solely for those earning less than $250,000 a year as proposed by President Obama.

Q: What does this mean for investors?

A: During the short- and intermediate-term, we see the stock market outlook as being very favorable. When September and October have posted gains for investors, as they did this year, during the following December the S&P 500 gained an average of 4% and was in positive territory to some degree 100% of the time. Although there are no guarantees, this year (remember history is a guide, not gospel), it is possible that investors who were awaiting election results could put their money to work before year-end. Standard & Poor's recommended sector positioning reflects a largely cyclical emphasis with a focus on what we view as dependable global growth at a reasonable price with Industrials, Information Technology and Consumer Staples recommended overweight. Conversely, S&P recommends underweighting more domestic sectors with limited earnings visibility, such as Financials and Utilities.