Will the Republicans win control of Congress? With summer drawing to a close, the midterm election is just two months away, and this question is likely to be analyzed and debated with increasing urgency.
But for the stock market, the answer may not matter at all: The market has a tendency to rally no matter which party wins a midterm election. That’s what the historical record suggests, anyway.
In fact, from the standpoint of stock market history, political outcomes aren’t very relevant, but the calendar is. September is typically a difficult and volatile month for stocks, while in a midterm election year the clouds over Wall Street have tended to lift in October. Regardless of which side has won in a November midterm election, the market has generally prospered for the rest of the year. And it has excelled in the next calendar year, typically the most propitious year for stocks in what is often called the four-year presidential cycle.
If you believe in this market cycle, we are now at an interesting moment.
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“Once we get past September we will be entering what has historically been the sweet spot of the presidential cycle,” said Ed Clissold, the U.S. market strategist for the Ned Davis Research Group and co-author of a recently published “Mid-Term Election Handbook,” which is concerned far more with the stock market than with congressional politics.
The Stock Trader’s Almanac has been slicing and dicing these market patterns since Yale Hirsch, its former editor, popularized them in its first edition in 1968. It has chronicled glaring differences in the performance of the Dow Jones industrial average that appear to be loosely linked to the political calendar.
Here are that compendium’s current calculations for the average annual gain of the Dow Jones industrial average in each year of a presidential term, going back to the beginning of the 20th century: 6.2 percent for Year 1, 4 percent for Year 2 (which this midterm year would be), 12.4 percent for Year 3 and 7.5 percent for Year 4.
What to make of all this? The data can be endlessly fascinating, in the way baseball or soccer statistics can be. (Forgive me, Britain: For you, it’s “football.”) They may be best used as light entertainment.
Goldman Sachs, you may recall, engaged in an elaborate statistical study to handicap the recent World Cup, predicting, erroneously, that Brazil would win it all and noting that, based on historical patterns, a victory could give Brazil’s stock market a one-month, 3.5-percentage-point performance edge. Brazil’s disappointing play in the World Cup demonstrated the limits of high-powered forecasting, but even if Brazil had won, it would have been the height of foolishness to have made an investment on the sole basis of any of those numbers. Still, they were fun for fans and market wonks to contemplate.
So let’s be clear: These are merely patterns, not reliable statistics. As the saying goes, past performance doesn’t guarantee future returns. Virtually no one recommends using historical market patterns as simple templates for investing.
“We believe these patterns are worth considering,” Clissold said. “But we don’t believe they ought to be anyone’s main input for investing.”
Why even consider them, then? Aside from their entertainment value, the most compelling reason is simple: They may help explain what is going on in the world. A sizable cottage industry of Wall Street prognosticators and academics regularly dabbles in the dark arts of election cycles, economics and market movements. In his seminal study, “Predicting Presidential Elections and Other Things,” Yale economist Ray C. Fair points out that the state of the economy and the results of elections for president and Congress appear tightly correlated. He hypothesizes that a strong economy helps the incumbent president and his party, and many analysts make similar assumptions.
Fair doesn’t use the market directly in his election equations; the growth rate of the gross domestic product, and the inflation rate, are the economic inputs he favors. (For now, his model shows that the midterm election is too close to call.)
The correlation between a political outcome and the movement of the stock market hasn’t been demonstrated in as compelling a fashion. There are theories, of course. Hirsch said that because presidents - and their parties - want to win elections, they manipulate the economy as best they can to assure favorable outcomes, and in so doing they affect the stock market. In a president’s first year, for example, he can afford to take tough measures, proceeding to stimulate the economy when the next election draws near, or so the theory goes. Academics have considered these issues, too. In most cases, the research has been inconclusive.
But oh, those numbers! They are endlessly intriguing: The stock market, for example, has generally done better under Democratic presidents than Republican ones. From 1901 through 2013, the Dow gained 7.9 percent, annualized, under Democrats, versus 3 percent under Republicans, according to Ned Davis data. Why?
Paul Hickey, co-founder of the Bespoke Investment Group, says: “It may be because we have a consumer-driven economy, and Democrats tend to spread the wealth around to lower-income people, who tend to spend it. The market may be responding to that.” Or not. “It’s possible that these are just numbers and don’t mean much,” he added. “We don’t really know.”
Then there are midterm elections under Democratic presidents, specifically. The market has done splendidly when Congress has been split, as it is now, with annualized returns of 10.4 percent, but there is a major caveat, Clissold said. The Obama years are the only ones since the dawn of the 20th century in which there has been a Democratic president with a divided Congress. “That’s not a very big data set,” he said wryly.
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There’s a little more data for a Republican-controlled Congress under a Democratic president, an alignment that occurred under both Bill Clinton and Woodrow Wilson, and in those years the Dow gained 9.6 percent, on average.
The record for midterm elections under lame ducks like President Barack Obama isn’t very deep, either. Since World War II, there have been four of them, during the presidencies of Dwight D. Eisenhower, Ronald Reagan, Clinton and George W. Bush. The midterm in November will be the fifth. For what it’s worth, the data is upbeat, Hickey said, with positive returns but less volatility than in elections during presidential first terms.
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Regardless of the outcome in the Senate, Republicans are virtually assured of retaining control of the House, so power in Washington will remain divided, and that’s been good for stocks, Hickey said.
“The market seems to like it when you don’t have one party controlling everything. It likes the status quo. And it likes it when administrations run out of steam,” which, he said, tends to happen by the middle of a presidential second term.
“Wall Street assumes a president at that point won’t get much more done,” he said. “And the market likes it when nothing much happens in Washington.”
None of this proves where the market is heading, of course, and it isn’t an uplifting gloss on the state of affairs in Washington. It does, however, suggest a cheery mood for the stock market over the next year or so. And if enough people believe it, that may even turn out to be true.