Why Midterms Matter to Investors

Estimated reading time: 6 minutes

Pre-Election Jitters

Welp, midterms are now less than a month away. Soon the elections will suck up all the oxygen in the room. 

Since Congress has the power of the purse, whichever party has a majority usually holds the keys to tax laws and fiscal spending. And because the government also accounts for about one-fifth of the U.S. economy, any changes in public policy affect corporate earnings and sector performance too. 

At the moment, both chambers of Congress are controlled by Republicans. They hold a razor thin margin in the House (219 seats versus 214 for Democrats), and a slightly more comfortable one in the Senate (53 versus 47 seats). 

Right now, traders firmly expect Democrats to gain a majority in the House, with Kalshi showing 89% odds. It’s less clear on the Senate side, however. There are numerous competitive races: Some are in your typical battlegrounds (Michigan and North Carolina), but others are in Blue states (Maine and New Hampshire) and Red states (Alaska, Iowa, Ohio, and Texas.) Prediction markets show momentum has swung toward Democrats of late, giving them 63% odds of taking the Senate.

Election season can bring lots of twists and turns, so it’s not unusual to see market volatility. 

But is that the reason for the choppiness we’ve seen over the last month or so? My gut tells me no. 

The Iran war and the buildout of AI — arguably the most important market drivers this year — depend more on who controls the White House than Congress. Still, we could potentially see a relief rally once the outcome is more clear. The simple rule of thumb is: More Uncertainty = More Risk.

Gridlock Dividend

One thing to keep an eye on is what happens after midterms. Almost without fail, stock market returns are above-average in the year after a midterm. Since 1950, the S&P 500 has had an average total return of 20.9% in the year following midterm elections, notably higher than the long-term average of 11%-13%. Those years also tend to be the best of each four-year presidential term by a comfortable margin.

It’s hard to assign a specific reason for this pattern, especially given how complicated the world is. 

One possible driver is simply mean reversion. Since midterm years underperform, it stands to reason they tend to bounce back the following year.

Another contributing factor could be Washington gridlock. If you have a split Congress, or one party controlling Congress and the other controlling the White House, it can be hard to pass major legislation. And if less gets done, it can (ironically) create a more predictable and stable business environment. 

Going back to that rule of thumb, Less Uncertainty = Less Risk, which is good for markets.

Interestingly, the data suggests there’s little preference in the outcome: Stock market returns are broadly positive whether one party controls both the presidency and Congress or they’re split. That’s also true if the House and Senate split between parties.

Here’s something important to keep in mind: Political news and election coverage can make even the best investors emotional, triggering impulsive or knee-jerk reactions. But history shows us that asset prices are ultimately driven by corporate earnings, economic fundamentals, and monetary policy — not political forces.

Looking to the Future

Once ballots are counted and the races are called, attention will shift from election night to what comes next. Barring a big surprise, we’ll have some form of split government. Even if markets  rally on the prospects of gridlock, though, could Washington still get stuff done?

Watch the AI space. Technology is moving so fast and its potential for disruption is so great that elected officials may have no choice but to do something. For instance, if there is some sort of grand bargain between the White House and Capitol Hill, it could significantly impact the valuations and earnings trajectories of the stocks that have been so vital to portfolios in the last few years.

Due to recently passed reconciliation bills, the future of corporate and individual taxes will also need to be addressed, and temporary provisions will either get re-upped, altered, or scrapped altogether. Plus we’ll probably go through more national debt limit brinksmanship — again — which will require negotiation and compromise too (unless we want to face the wrath of the bond market). 

And you know what? In relatively short order, we’ll start to talk about the 2028 presidential election, and get to do this political horseracing all over again. Of course, that will have even more fireworks.

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