A Peek at 2014 Midterm Elections’ Potential Impact on Your Portfolio

Editors’ Note: Our discussion of politics and elections is purely focused on potential market impact. Neither Republicans nor Democrats are favored by stocks. Believing in the market/economic superiority of one group of politicians over another can be a source of bias—and investing on biases can cause significant investment errors.

Midterms. They aren’t just college exams—they’re also methadone for political junkies in between Presidential election years. And with Congressional election rhetoric heating up, many wonder what the contest means for markets. In our view, whether the Republicans or Democrats gain a few seats in either chamber, the likely outcome is (drumroll): Gridlock! Something stocks love.

For gridlock to end, the Democrats would need filibuster-proof majorities in both houses. This is exceedingly unlikely—structure and history favor a split Congress. The Senate contest favors a continued but smaller Democratic majority. Republicans have fewer seats to defend, and history shows the President’s party tends to lose seats during midterms. However, to gain a majority, Republicans would need to pick up six of the 21 Democratic seats up for re-election and defend all 15 of their own. Republicans’ defense looks easy compared to Democrats, considering GOP-incumbent races are largely in traditional Republican strongholds. The Democrats must defend six seats in states that voted Republican in the last four Presidential contests. Sweeping these would require the Republicans to repeat their landslide victories in 1994 and 2010—not impossible, but it would take near-flawless campaigning. In our view, the most likely outcome is a slim Democratic majority. In the House, structural factors are somewhat reversed—the likely outcome being a continued but smaller Republican majority. Since incumbents are hard to beat, the key is to look for open seats. As of April 11, 2014, the House has 18 open seats—13 Republican and 5 Democratic. For the Democrats, winning a majority would require taking all 13 Republican open seats, stealing one from a Republican incumbent and losing zero. It wouldn’t shock if the Democrats gained some ground, but the likelihood they take the House is extremely low.

In short, the likely outcome is gridlock—a big positive for markets. Headlines tend to deride gridlock, claiming we need a functional legislature to pass supposedly growth-enhancing legislation. But in an economy with a robust private sector, ample private property protections and overall growth, markets tend not to like legislation much. They’re wary of unintended consequences that stem from even the most well-intended measures. When the chance of passing big, sweeping legislation is slim, legislative risks fall.

But some say midterm elections impact markets differently. Midterms mean it’s the second year of a presidential term, and year two has the lowest average historical return of the Presidential cycle. Some suggest this means lackluster returns ahead. But second years of presidential cycles aren’t inherently bad—they’re just more variable. Much of the historical weakness is concentrated in first terms, when legislative risk is high. But this is Obama’s second term. Year-two returns in Bush’s, Clinton’s, Reagan’s, Eisenhower’s, Truman’s and FDR’s second terms (and FDR’s third term) were all above-average. At this point in Obama’s tenure, markets know what they’re dealing with, and with gridlock reigning supreme, Obama’s major legislative feats seem to be in the rearview.

Some look a little shorter term, theorizing pre-election uncertainty will spook markets over the next two quarters, pointing to lackluster S&P 500 price returns during Q2 and Q3 in midterm years. However, coincidence isn’t causality, and averages aren’t predictive (and total return tells somewhat of a different story). In this case, the averages are skewed down by bear markets in 1990 and 2002 and corrections in 2006 and 1998—midterms weren’t meaningful drivers here. Maybe stocks do follow their paths in 2006 and 2010, waiting until the back half of the year to take off. But maybe not! Markets like fooling investors. If most folks expect pre-election jitters, markets discount those expectations and could very well do something else instead.

If you’re waiting for an election all-clear, in our view, it’s a fool’s errand. Markets are forward-looking, and they’re likely already well aware of the election’s probable outcome. Chances are they’ll start digesting the likelihood of gridlock before the votes are tallied.

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