Elections are on the way: It could get bumpy on your way to the polls

A perspective from E*TRADE Securities1

10/26/18

It’s that time again. Lawn signs, attack ads, and pols hamming it up in newly purchased flannel shirts: Midterm elections are just around the corner.

We’ve been covering this issue for some time as a possible market risk, but with November 6 a little over a week away, this is where the rubber meets the road. What could next month’s midterm elections hold for the markets?

First, let’s get a lay of the land:

The current political backdrop

As it stands now, Republicans are in full control of all levers of government: the White House, the House of Representatives and the Senate, and 33 statehouses. But that could change after November 6.

House: 218 seats are required to control the House of Representatives. With Republicans comprising the majority, Democrats need to flip 23 seats to get to that number. It’s entirely possible. Many competitive House districts held by Republicans leaned Democratic in the 2016 presidential election and are polling to favor Democrats once again.

Senate: In the Senate, 35 of 100 total seats will be voted on next month. Republicans hold a 51-seat majority and political pundits believe they stand a good chance of retaining, or even increasing, their majority position.

State and local races: Often overlooked, state and local contests will also be voted on in November. In particular, 36 state governor’s seats are up for grabs. This is a pretty big deal this go-around, as states must approve the redrawing of congressional districts, which will happen following the release of census results in 2020.

Potential ramifications for investors

What does this all mean for investors and the markets? In a word, uncertainty. October is a notoriously volatile month in the financial markets, especially during election years, and uncertainty unnerves investors. Will a newly elected Congress favor more regulation? Will lawmakers pass tax cuts that could affect the economy? Will there be legislative gridlock? Investors simply don’t know, which can cause many to take profits and sit on the sidelines.

What’s the historical record?

Fortunately, we can look back to history as a guide. According to the Wells Fargo Investment Institute, the volatility we’ve experienced of late is not altogether unusual. And the upshot is that markets have historically rallied following the midterms. In fact, over a 52-year period through 2014, the S&P 500® Index has fallen by an average of 19% in the year-to-date period preceding midterm elections but has gained an average of 31% in the 12 months following midterm elections.

S&P 500 Index, pre- and post- midterm elections

Source: Wells Fargo Investment Institute. Returns reflect year-to-date period preceding midterms, full-year period following midterms.

Of course, past is never prologue when it comes to the markets, and this year has some unique qualities. A long bull market and strong economic fundamentals are fighting an undertow of higher interest rates and tariffs, which have put a dent in some corporate earnings and pressured equities.

Split or unified government? It could make a difference

To add another wrinkle, it’s not just elections that can move the markets. Historically, Washington, DC’s political makeup has also correlated with stock market returns.

As you can see from the chart below, some of the best equity returns have come during periods of unified government, when both the legislative and executive branches were controlled by one party. However, that may not be what we see on November 7. Should the sitting Republican president end up with a split Congress this November, the S&P 500 has a lackluster tale to tell.

S&P 500 performance under different governing scenarios

Source: Standard & Poor’s Equity Research. Returns reflect full calendar years for midterm election years.

Focus on long-term goals

While it can be tempting to try to time the markets during election years, the Ouija board approach can often lead to poor investment decisions. Regardless of how investors see the political winds blowing, they should always keep an eye on maintaining a disciplined, long-term approach, with a diversified mix of holdings mapped against their risk tolerance and goals.

In other words, diversify appropriately, look past the noise, and stay the course. Pretty catchy slogan. Maybe we should try running for office.