After a difficult, fearful first half, so many worry only worse lies ahead. But this year’s second half holds a secret stock market force hiding in plain sight: America’s midterm elections. Yes, those raucous contests voters hate. They routinely deliver the relative or absolute gridlocked, do-nothing governments stocks love—and buoy markets in route. Let me explain.American investors routinely squabble over whether Democrats or Republicans are “better” for stocks and the economy. They fearfully parse administration talking points and policy positions, presuming they must spell trouble. But this is mostly theater. Look beyond it and see: in the approximate 30 months ahead stocks pre-price they don’t much prefer one political party or politician over another. Their big concern is big, controversial, economically significant legislation.Big always bills create winners and losers. Behavioral finance shows people hate losses over twice as much as they like gains—rendering sharp legislation a net negative for markets. Active governments brew uncertainty, which stocks hate. Businesses have a harder time planning, knowing rules likely change unpredictably. Investors grow leery deploying long-term capital. Gridlock assuages those worries—fast.January 2021’s Georgia runoffs gave the Democrats nominal control of the White House and Congress, but the edge was historically miniscule. Hence, I concluded that internal divisions within President Biden’s party meant sneaky gridlock would still hamper most of what Democrats proposed. In my experience, around two-thirds of investors lean Republican, so that would be an unconscious relief. That largely played out, with many pricey proposals deeply diluted—like Build Back Better—or abandoned altogether. Still, party-line votes squeaked through some major reconciliation based spending bills, like 2021’s $1.9 trillion COVID relief package. Single-party control—however slim—gives one party full control over what comes to a vote and what doesn’t—100%. So zombie plans like Build Back Better hold lingering life—prolonging fear.But midterms should shatter most remaining fears. Consider: The president’s party has gained House seats in only one midterm since World War II—2002’s, when post-9/11 patriotic fervor netted George W. Bush’s Republicans a mere eight seats. Furthermore, a president’s popularity at June’s close is a harbinger of midterm fortunes. Since WWII, parties of unpopular presidents—those with below-average approval ratings—have lost an average 38 House seats. Biden? His 41% approval is significantly below-average. That suggests a huge likelihood Democrats’ paltry 10-seat House edge goes poof on November 8.The Senate is murkier. Yes, Republicans could flip it by gaining a single net seat. Can they? Most polls in the five key contested races—Arizona, Georgia, New Hampshire, Nevada and Pennsylvania—show Democrats leading. But in 2020, Republican Senate candidates fared several percentage points better than projections. They took every seat where late polls put the margin within three points either way—except Georgia’s two. In South Carolina, Iowa and Maine, GOP senators won decisively despite Democratic candidates leading polls on the election’s eve. Pollsters say they fixed the glitches. We’ll see. They’ve said that before, too. Polling is exactly very accurate despite all great intentions.Then, too, at least one current GOP Senate seat—retiring Pennsylvania Sen. Pat Toomey’s—is tilting blue—so Republicans may need to unseat more than one Democrat. Mid-June polls show Lt. Gov. John Fetterman (D) leading Republican Mehmet Oz—though Fetterman’s recent stroke clouds his campaign. Polls show Fetterman ahead, but he isn’t on the trail while recovering. Meanwhile, Oz is well-funded and a good speaker. The race could tighten.In Georgia, football legend Herschel Walker’s strong early numbers flipped fast. The GOP candidate trails incumbent Democrat Raphael Warnock in mid-July polling.Nevada looks toss-up like, with two former state attorneys general—Republican Adam Laxalt and incumbent Democrat Catherine Cortez Masto—already spending millions on attack ads. Polls show a tight race likely staying that way.Arizona and New Hampshire still await August and September GOP primaries—an edge for incumbent Democratic Senators Mark Kelly and Maggie Hassan who don’t face material primary opposition, while Republican challengers wage intra-party battles. New Hampshire’s GOP primary has more contenders than God has little green apples and no material front runners, a real intra-party problem. Late primaries require fast pivots—and wise spending. Incumbents can focus on November.However the Senate goes, a Republican-controlled House would reveal solid gridlock—rocket fuel for stocks. Since good data start in 1925, America has held 24 midterms. Stocks typically meander the first three quarters of those years as rancorous rhetoric sparks uncertainty. Only 55% of quarters are positive, 2022’s difficult first half included.But Q4 regularly brings gridlock, with stocks beginning to rally in anticipation at some perfectly unpredictable point, sometimes starting in the third quarter but routinely romping in the fourth. Again since 1925, returns are positive 83% of midterm years’ Q4s, with 6.3% average gains. They are 88% positive in each of the following Q1s and Q2s, too—average returns are a sparkling 6.6% and 5.5%, respectively, as campaigns’ far-flung promises fade to inertia and inaction.
I generally think markets are too efficient for these patterns this obvious to persist. But politics defies this, especially now. Deep-seated political biases and today’s vitriol mean Republicans and Democrats alike are so certain the other’s policies signal doom they overlook gridlock’s power to squash them. They grasp at straws like Executive Orders and rhetoric to argue their fears are real.I fully realize a cavalcade of scary stories made this year’s first half far worse than typical midterm years’ wobbly starts. But relief approaches. Be sure you don’t miss midterms’ magic, which should arrive just as many of today’s fears fade.
