Earlier this year, investors anticipated a “Blue Wave” sweep and were betting on a major market decline to result. This expectation was evident in the derivatives market as early as April. On Election Day, as the results began to come in and it appeared that the Republican Party would hold the Senate, investors began to cover their bets on a market decline by purchasing to cover their short positions. This continued into the trading day, causing the U.S. equity markets to jump 4.5% in the first few hours of trading.
No matter whether one is happy or not regarding the outcome of Georgia’s senatorial elections, at least one thing is clear: the Democratic Party now controls the White House, Senate, and House. Let’s call that DDD. The $64 question is how stock markets will perform in such a one-sided political environment.
Let’s look at the evidence.
Our examination of the historical record found that voters and markets alike prefer a government split between political parties. Unfortunately, the two groups preferred split is not identical.
Dating back to 1952, 32% of the time, voters preferred a Republican in the White House and a Democratic Senate and House (RSS).
Historically, however, this configuration offered the lowest annualized average market return of 4.32%.
In contrast, the markets’ preferred split appears to be a Democrat in the White House and a Senate and House controlled by the Republican Party (DRR). This combination has historically offered the highest annualized average market return of 16.46%.
The second-best market returns emerge in a pattern where the White House and Senate are controlled by one political party, and the House is controlled by the other political party (DDR or RRD). This pattern, dating back to 1952, offered a historical annualized average return of 13.8%, with a slightly higher return generated under a Republican-controlled White House and Senate.
A pattern when the White House and the House is controlled by one political party and the Senate is controlled by the other political party (DRD or RDR) has occurred only once, not enough to extrapolate any useful historical record. In fact, a White House and the House controlled by Democrats and a Senate controlled by Republicans has never occurred over the period we studied. That would have been the political breakdown had the Republicans salvaged at least one of the Senate seats in Georgia.
But we now know that it was indeed a “Blue Wave.” Such a DDD is not unprecedented. In fact, it has occurred 25% of the time since 1952 and is the second most common pattern of government control over the last 70 years. The average return during those periods is just under 9%—not too shabby.
While we’re not inclined to bank on that 9% return, at least the historical record gives us some confidence that we shouldn’t run for cover. So, if we rule out such an extreme reaction to DDD, what should an astute investor do?
If you believe the Chapman Economic Forecast (and you should!) that calls for a robust 5.7% increase in real GDP, then corporate profits look pretty good in 2021. Such a rosy outlook is supported by another round of fiscal stimulus (CARES Act II), and more importantly, everyone getting vaccinated against COVID-19 by early summer, if not sooner.
We can’t conclude and truly call ourselves economists if we didn’t add the caveat, “On the other hand.” So, on the other hand, if the recovery is even stronger than we think, keep your eyes on inflation and long-term interest rates.
If the 10-year T-bond continues to increase to rates that begin to rival the E/P ratio, then it may be time to run for cover.
But to end on a more positive note, at least, we’re not worried about DDD.
Editor’s Note: James Doti is the principal author of Chapman’s annual economic forecasts, which ranked first for accuracy among 23 forecasters from 2004 to 2019, and is also on the board of directors of Whittier Trust, which has $14.7 billion in assets under management. Fadel Lawandy has more than 25 years in the financial industry, including as a portfolio manager for Morgan Stanley.