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WashingtonWise Investor: Episode 29


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Election Upon Us: How Might the Market React?

In this episode of WashingtonWise Investor, Mike Townsend previews what to watch for on Election Night.

In this episode of WashingtonWise Investor, Mike previews what to watch for on Election Night and discusses whether the market cares about the election outcome with Randy Frederick, Schwab’s vice president for trading and derivatives. They also explore what lessons can be learned from market reactions to previous elections, why traders are betting on volatility this November, and why investors should be wary of making big changes based on the election outcome.

Mike also provides updates on the never-ending economic stimulus negotiations, the newest Supreme Court justice, and why what happens in races for seats in the House of Representatives could really matter.

WashingtonWise Investor is an original podcast from Charles Schwab.

If you enjoy the show, please leave a rating or review on Apple Podcasts.

Click to show the transcript

MIKE TOWNSEND: It’s finally here. After two years of campaigning, 32 major-party presidential candidates, a record of nearly $11 billion in campaign spending, two presidential debates, countless town halls, endless television advertisements, and hundreds of polls, Election Day 2020 is finally upon us.

Sometime next week—or maybe a little longer if races are close—we will know who will occupy the White House for the next four years and which party will control the critically important United States Senate.

Welcome to WashingtonWise Investor, an original podcast from Charles Schwab. I’m your host, Mike Townsend, and on this show, our goal is to cut through the noise and the nonsense of the nation’s capital and help investors figure out what’s really worth paying attention to. Today is our last episode before the election, and in just a minute, we will look back to see what history tells about how markets react to elections and look ahead to what to watch for as the returns come in.

But first, two quick updates on the news of the day.

First, earlier this week, the Senate confirmed Amy Coney Barrett to the vacancy on the Supreme Court. The vote was 52-48, with one Republican joining the 47 Democrats in opposition. Coney Barrett was sworn in on Monday evening, and so begins her tenure as a justice.

The vote capped a lightning-fast confirmation process that was unprecedented in its proximity to a presidential election, and the 30 days from Barrett’s nomination to her confirmation is the fastest process since the 1975 nomination of Justice John Paul Stevens.

Republicans got their wish of ensuring that Barrett sits on the Court for a case involving the Affordable Care Act that will be heard on November 10, and, of course, she will be able to hear any cases regarding the election, should any legal challenges make their way to the nation’s highest court in the weeks after Election Day.

But the long-term impact of this process could be even more profound. And it’s not just the fact that this was a lifetime appointment of a 48-year-old justice who could sit on the Court for a generation and make decisions that dramatically affect the direction of our country.

The impact on the Senate could also be enormous. The bitterness between the two parties in the Senate is unlike anything I have ever seen before. If Democrats win back the Senate majority in next week’s election, even the most routine business could become nearly impossible in 2021, given the animosity between the parties. Democrats could move quickly next year in retaliation for the rushed confirmation process, perhaps by ending the legislative filibuster or even by expanding the size of the Supreme Court. It does not bode well for finding bipartisan consensus on much of anything in the years ahead.

Speaking of bipartisan consensus, or the lack thereof, we’re still talking about economic stimulus. It’s been more than six months since Congress passed the fourth and final stimulus bill after the pandemic began. Those four bills, which totaled about $2.8 trillion in aid, were all passed unanimously or near-unanimously by the Democratic-controlled House and the Republican-controlled Senate. It was a rare burst of bipartisanship in a bitterly divided Congress.

Unfortunately, it was also short-lived. Since then, of course, Congress has been unable to agree on another bill. House Speaker Nancy Pelosi and Treasury Secretary Steven Mnuchin have been negotiating for weeks—and those talks have continued even into this week before the election. There’s no question that they have narrowed the overall gap—reportedly, Pelosi is at about $2.2 trillion, while Mnuchin has come up to about $1.9 trillion. But significant divides still exist on issues like funds for state and local governments and liability protections for business. And nothing has changed for the Republicans in the Senate, most of whom remain opposed to another stimulus bill.

Now, politically speaking, there’s no downside to Pelosi and Mnuchin continuing to talk, which they have been doing nearly every day for the past several weeks. And there is no downside to sending out the message that they are making progress, that they are “closer than ever” to a deal, that just a few details need to be worked out. The market clearly likes it when the two negotiators send positive signals that a deal is imminent. But no one really thinks a deal will get done this week—and at this point, neither the House nor the Senate is even scheduled to be in Washington until after the election.

We will see whether the situation changes after the election—typically, that’s a time when intransigent positions suddenly become much more flexible. The market clearly is anticipating a significant stimulus bill to pass at some point in the not-too-distant future—and I don’t think investors are wrong to think that. The question now is whether it will happen in that November/December post-election session of Congress, or whether it will wait until the January/February timeframe, when a new Congress is in office and, perhaps, there is a new occupant in the White House. Stay tuned.

On my Deeper Dive this week, I want to look at how the market has reacted to past elections and whether there are lessons to be gleaned from history.

Joining me is Randy Frederick, Schwab’s vice president of trading and derivatives, and someone who spends a lot of time analyzing what has happened with the markets in the past and what that can tell us about the markets of the future. Randy, thanks so much for joining me.

RANDY: You’re quite welcome, Mike. It’s great to be back with you again.

MIKE: Well, Randy, let’s begin with addressing one of the most common questions that you and I get every election cycle, which has to do with whether the market has a preference for a particular outcome. There are a lot of myths out there about the market preferring certain political configurations—like maybe it prefers a generic Republican president over a generic Democrat. Or it prefers divided government and gridlock. Is there any truth to these myths?

RANDY: You know, Mike, like most statistics, you can probably find ways to spin these numbers to say just about anything you want. Some people, for example, will use the Dow Jones Industrial Average, and some will use the S&P 500®. This can make a huge difference in the result. For example, as of the close on Friday, October 23, the Dow was down nearly 1% year to date, whereas the S&P 500 was actually up more than 7% year to date.

Another way to spin them is based on how far back you go in time. The New York Stock Exchange was founded in 1792, which was only three years after George Washington was first elected president. Results going back that far might look a lot different than the results in just since, say, the post-WWII period.

So before we answer this question, we have to agree on the parameters. Personally, I generally prefer to use the S&P 500—since it’s a broader index and more representative of the stock market overall—and to focus only on the post-Depression era. And there are several reasons for this.

First of all, we’ve had only two major political parties during that period of time, whereas going further back in time, you’ll find 11 early presidents who were Federalists, Democratic-Republicans, Whigs, or Unionist parties, and those parties don’t exist today, so where would you put them?

And secondly, the investing environment changed dramatically in the post-Depression era with the introduction of the Federal Reserve, the Glass-Steagall Act, the FDIC, the SEC, and much more. So from my perspective, the modern investing era really didn’t begin until after the Great Depression.

MIKE: OK, so stipulated. So what does the actual data tell us?

RANDY: Well, if we focus only on presidents elected since the Depression and we use the S&P 500, we find that the average gain in the S&P 500 has been about 40% under Democratic presidents and about 27% under Republican presidents. But there are several qualifiers that I think need to be mentioned here.

With Roosevelt serving more than three terms, Democrats have held the office for 14 terms, while Republicans have only held the office for 11 terms.

President Roosevelt and President Obama were both elected during severe bear markets, which allowed for significant upside potential.

And President Clinton, whose two-term results are the highest of all, was elected early in a very long bull market that had just started winding down a few months before he left office at the end of his second term.

So it may be that the Democrats have a little bit of a structural advantage in this question.

MIKE: OK, but of course, we’re only looking at half the equation here. What happens when we add in the other half—Congress? Does a particular pairing of which party occupies the White House and which party controls Congress make a difference to the market?

RANDY: So there’s an old adage that says the market likes political gridlock—and that’s referring to a divided government or the makeup of Congress, which as I’ve heard you say for many years is often far more important than the party affiliation of the actual president. With two political parties, the House, the Senate, and the presidency to consider, there are actually only six possible outcomes:

So we can have a Democratic president with either a Democratic Congress, a Republican Congress, or a mixed Congress; or we could have a Republican president with either a Democratic Congress, a Republican Congress, or a mixed Congress.

Now, our colleague Liz Ann Sonders recently published an article on election history showing that the markets have typically performed best when the president was a Democrat and there was a split control of Congress. Of course this is a little bit misleading, because the only time this makeup actually existed was during President Obama’s second term. And that’s hardly a statistically significant slice of the past century.

Additionally, the only scenario where the market was overall negative during a presidential term was when there was a Republican president and a mixed Congress. This occurred in the latter part of both the Nixon presidency and the George W. Bush presidency. Interestingly enough, that’s what we have currently, and the markets have actually done quite well under President Trump.

It turns out that the most common structure in Washington happens to be the one that markets are perceived to like the least, and that’s when one party controls everything. Historically, Democrats have been in that position about one-third of the time, and Republicans have been in that position about a quarter of the time, and frankly, the markets have actually had very similar and very average performance in both cases.

MIKE: So Randy, it sounds like all of these historical results may be more a matter of chance than who occupies the White House or what party controls Congress. If that’s true, then what does influence the market?

RANDY: Well, yes, chance and fundamentals. And that means things like economic data, monetary and fiscal policy, inflation rates, labor markets, etc. It’s very common for a president to take credit for, and sometimes get blamed for, the strength or weakness of the economy and the performance of the stock market while he was in office. But I do believe the dramatic gains during things like the Roosevelt and Obama presidencies had as much to do with how terrible things were when they actually took office as they did with the policies they implemented.

One might argue that President Trump perhaps gets too much credit for the 62% gain during his first term, because he took office during a market that had already risen 112% under President Obama’s two terms. But if that’s true, he at least deserves credit for keeping the bull market going.

Likewise, one could argue that President George W. Bush was maybe just a victim of bad timing. Market performance under his presidency was dead last for both his first term, which included the last three years of the bear market after the dot-com bubble and the World Trade Center attack, and his second term, which included the first two years of the great financial crisis. 

And Bill Clinton who was first elected in 1992 during a bull market that had been going on for two years already. By the time he left office at the end of 2000, the next bear market had already been going on for nine months, but it hadn’t yet declined 20%. So does he deserve credit for the 241% gain during his two terms?

MIKE: Well, Randy, I think this is a critically important point—there are just so many other factors that affect market performance much more than the political configuration of Washington. Let’s turn our attention to more recent history. As you well recall, equity futures plunged on Election Night in 2016, as Donald Trump’s surprise victory took shape. But then the next day, the market surged. Why do you think that was?

RANDY: Well, one thing we know is that the market hates surprises. And when it gets surprised, the first reaction of traders is usually to hit the sell button. Then after everyone has a moment to digest the news, often times it will reverse and move higher.

I think Election Night in 2016 is probably the most extreme example of this. Virtually all of the polls had expected Trump to lose, but when some of the returns started to come in from a few of the key battleground states at around 7:00 p.m. ET, S&P futures dropped 5% in only like 20 minutes, and then they got halted. It was probably the steepest and sharpest selloff I have ever witnessed.

But by the time equities opened at 9:30 a.m. in New York, the S&P was down only a small amount. The S&P 500 then went positive around noon on the day after Election Day, and by the time it closed it was actually 1% higher. From there it rallied for 15 straight months—gaining about 34%—as investors came to realize that Trump was very pro-business.

It’s probably worth mentioning two more recent examples when the market sold off after being surprised.

So just a few weeks ago, at around 1:00 in the morning on Friday, October 2, news broke that President Trump had tested positive for the coronavirus. S&P 500 futures immediately fell about 62 points, but by the market open, they were only down about 40 points, and by the time the market closed that day, they only ended up down about 32 points.

Then, a week later, on Tuesday, October 6, approximately an hour before the markets were closing, President Trump tweeted that all negotiations on a new coronavirus stimulus package should stop until after the election. That tweet immediately turned what had been about a 0.7% intraday gain on the S&P 500 into a 1.2% decline in a matter of only 15 minutes—it was a dramatic 75-point drop.

I dare say that if President Trump pulls out another victory this time, despite the polls favoring Biden by even a larger amount than they had favored Hillary Clinton, markets would likely decline quickly on the news again. Not because a second term of President Trump would be bad for the markets, but simply because it would be a surprise. And I would urge investors not to react to the first move in the markets if that happens again.

MIKE: Randy, as you point out, it’s often said that what markets dislike the most is uncertainty. Looking at the 2020 election, there is a lot of concern about uncertainty—that the outcome could be disputed or get tied up in legal challenges, such that we have a period where we’re not sure what the outcome is. I am assuming we can expect some volatility if the election result drags out and is highly contested. Are traders making moves to hedge against or profit from that volatility?

RANDY: Well, as you know, 2020 has been a very unique year in so many ways. After the sharp, quick bear market that was caused by the coronavirus, the S&P 500 has sharply outperformed in the spring and the summer months leading up to the election. The S&P 500 is actually up more than 50% since the March 23 bottom. Then it lost about 9% in September but, here in October, it has gained much of that back.

Now, the Cboe Volatility Index®, or the VIX®, is a volatility gauge that many investors have become very familiar with. While its intention is to forecast market volatility 30 days into the future, many investors use it as a real-time gauge of market uncertainty, or even anxiety. You may recall that the VIX spiked to an all-time high of 82 back in the springtime, and while it has come down somewhat, it has remained elevated well above normal levels for the past six months. Now, I believe this is almost entirely due to the uncertainty about not just the outcome of the election, but also how long it may take before that outcome is known—and whether or not there will be a peaceful transfer of power.

Now, VIX futures, which are intended to forecast volatility many months out, have actually been pricing in this election risk since way back in February of this year; a sizable pricing spike in the October expirations have been visible ever since then. Within just the past couple of weeks, however, VIX futures have begun pricing in an even higher spike in November, which is highly unusual because those contracts actually expire after the election. Now, the way these products work, the VIX Index and the VIX futures must converge at expiration. Now, sometimes that means that the VIX Index will rise, and sometimes that means that the VIX futures will fall; most of the time it’s a little bit of both. And that means the VIX Index will likely remain elevated and possibly even increase a little more over the next few weeks, regardless of how the market performs.

Interestingly enough, though, not everyone believes that will happen. In just the past few weeks, there has been a sizable uptick in volume on VIX put options. We’ve even seen some multi-year highs and even all-time highs in the VIX put/call ratios. In other words, there has been an enormous amount of activity indicating that some market participants are now expecting a sharp decline in volatility, immediately following the election. What seems to be driving this trend is that changes in implied volatility have made these VIX put options very, very cheap relative to the price of the VIX call options. And that’s causing some speculators to buy them up, just in case the election, the vote count, the transfer of power, and all that stuff goes quickly and smoothly. A belief that a volatility spike related to the election is inevitable has become such a crowded trade that some traders have decided to start taking the other side.

MIKE: That’s really interesting, Randy, thanks for explaining that to us. Well, speaking of contested elections, the last one we had was in 2000, of course, Bush versus Gore—how did the market react to the uncertainty then?

RANDY: In 2000, the S&P 500 underperformed both before and after the election, dropped about 6.2% in the seven months prior, and then another 5.6% in the week immediately following the election. But even more fascinating was that there was a second selloff of about 7.8% in the week following the final Supreme Court ruling in mid-December. So even once the results were finalized, the market still wasn’t happy.

As I discussed previously, this was probably less about the election and more about the bear market, which had already begun nine months earlier. I suspect the actual outcome of the election would have made little difference in the bear market, which lasted for nearly two more years.

MIKE: Well, Randy, in your opinion, how should long-term investors be thinking about the election and these different possible outcomes?

RANDY: Very small strategic changes prior to the election might make sense for some investors. Certainly if you believe capital gains taxes might go up, taking a few profits in 2020 could be a smart move. But as you know, Mike, what a presidential candidate promises and what can actually be turned into law are often miles apart. And just because a candidate wants to make a particular change doesn’t mean he can or that he will.

I often remind investors that even if we could predict with a high degree of certainty which candidate was going to win the election, we wouldn’t necessarily know how the market will react. Remember, back in 2016, not only was Trump not expected to win, but most forecasters thought that if he did win, the markets would sell off. But as we’ve already discussed, other than a very brief surprise selloff only on Election Night, the markets rose 34% over the next 15 months.

As Liz Ann pointed out in that same article on election history, in the last 120 years—now, I know that’s a long time horizon—while markets have gained over 800% under Republican presidents and over 4,000% under Democratic presidents, they’ve actually gained 40,000% over that entire time period. And if that isn’t a compelling enough argument to stay invested in the market regardless of who wins, nothing is.

MIKE: Well, Randy, you’ve given us some terrific perspective today, but probably none more important than that final comment. Making investing decisions based on who you think might win an election and what they might do afterwards is just not a good idea.

Randy, thanks so much for talking to me today.

RANDY: It was my pleasure, Mike.

MIKE: That’s Randy Frederick, Schwab’s vice president of trading and derivatives. You can follow him on Twitter @RandyAFrederick.

With that history lesson in mind, I want to spend just a few minutes looking ahead. Here’s what I’ll be watching for on Election Night and, potentially, in the days immediately afterwards.

First, in the presidential race, I’ll be watching the returns in eight critical battleground states. At the top of the list is that perennial swing state Florida. There is almost no scenario in which the president can be re-elected without winning Florida—if Joe Biden wins the Sunshine State, where polling has him ahead by the narrowest of margins, it likely signals a long night ahead for Republicans.

Arizona, Iowa, North Carolina, and Ohio are also closely fought states that will be critical to determining the outcome. President Trump won all four in 2016 and will need to do so again to have hopes of a second term.

But as happened four years ago, it could come down to three northern states—Michigan, Pennsylvania, and Wisconsin. In 2016, all three went narrowly—and unexpectedly—for President Trump. The three states had previously formed what politicos referred to as the “blue wall,” since all three had voted for the Democratic candidate in at least six consecutive elections prior to 2016.

All three are very much in play again. But a week out from the election, polls were showing Joe Biden leading all three by fairly comfortable margins—9 points in Michigan, 4 points in Pennsylvania, and 5.5 points in Wisconsin. All three broke very late for the president in 2016, so things could change. But if those margins hold, they will propel Joe Biden to the presidency.

We’ve talked on previous episodes of this podcast about the likelihood that we won’t know the outcome on Election Night, mostly because the tens of millions of mail-in ballots this year just take longer to count. And several of the battleground states have rules that may exacerbate that. In Pennsylvania and Wisconsin, election officials are not allowed to even begin opening and processing mail-in ballots until Election Day, and in Michigan, officials are only allowed a one-day head start. And Arizona is another state that has a history of high mail-in ballot rates that result in slow and methodical vote counts—in a close 2018 Senate race there, the outcome was not clear until six days after Election Day.

If these key battlegrounds are close, it could be several days before a result is known.

Second, for the battle for control of the Senate, I’ll be watching races in three states: Iowa, Maine, and North Carolina.

Republicans are heavily favored to pick up a Democratic-controlled Senate seat in Alabama, while Democrats are likely to flip seats in Arizona and Colorado. If that happens, Democrats would need to pick up two more Republican-held seats to forge a 50-50 tie in the Senate, a tie that would be broken by Vice President Kamala Harris if Joe Biden wins the presidency.

Iowa, Maine, and North Carolina are the three most competitive Senate races on the map. Whichever party wins at least two out of three is almost certain to hold the majority in 2021.

Finally, I was asked the other day why no one seems to be talking about the House of Representatives this election season. We hear non-stop coverage of the presidential race, of course, while I and many others have said countless times that the battle for control of the Senate may be the most important aspect of the election for investors.

But this election will also feature contests for all 435 seats in the House. In the final debate, President Trump said that Republicans would win back the majority. Now that would be a true election surprise.

Democrats currently hold a 232-197 margin in the House. There is one independent, and there are currently five vacancies. Most pundits think it is more likely than not that Democrats will expand that majority next week, that the risk of Democrats losing seats in the House is low, and that the chances of Republicans taking back the House majority are infinitesimal.

But there is one big reason to pay attention to what happens in House races on Election Night.

That’s because the new House of Representatives would have a role to play in the highly unlikely, but not completely impossible, scenario that neither Donald Trump nor Joe Biden reaches the 270 electoral votes needed to become president. Maybe the race ends in a 269-269 tie. Or maybe there are one or more states that are still in dispute when the Electoral College meets to vote in December, and the electors from those states can’t or don’t vote.

If neither candidate gets to 270 electoral votes, then the House of Representatives would choose the president. And each state gets a single vote. That’s why next week’s election of House members matters—because it could be crucially important what the party make-up of each state’s House delegation is.

Currently, 26 states have a majority of Republican members, 22 states have a majority of Democratic members, and two states are tied. If that scenario remains the case in January, when the new Congress is sworn in, and the presidential election is in dispute and goes to the House for a final decision, then Republicans would have a majority of the votes and would likely choose President Trump.

But if just a couple of seats change hands in just a couple of states, Democrats could have the majority of state delegations and would likely choose Joe Biden.

It’s far-fetched and highly unlikely. But it’s as compelling a reason as any to keep an eye on how the voting for members of the House of Representatives unfolds.

Well, that’s all for this week’s episode of WashingtonWise Investor. We’ll be back with a new episode in two weeks, when we’ll break down everything that happened on Election Night and what it means for the markets with the incomparable Liz Ann Sonders, Schwab’s chief investment strategist.

Please take a moment now to subscribe so you don’t miss our next episode. And if you like what you’ve heard, leave us a rating or a review on Apple Podcasts or your favorite listening app—those ratings and reviews really do matter.

For important disclosures, see the show notes or, where you can also find a transcript.

I’m Mike Townsend, and this has been WashingtonWise Investor. Wherever you are, stay safe, stay healthy, make sure you vote, and keep investing wisely.

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