Here's What the Midterm Elections Could Mean for Your Investments

Investors are on the edge of their seats this election cycle...

And it's not for purely political reasons.

Right now, Democrats control both the Senate and the House of Representatives. Neither majority is safe, though... Both are up for grabs in the midterm elections on November 8.

Astute investors should be wondering how the outcome might change market performance over the next two years.

Because sentiment changes constantly, it's important to keep an eye on election data.

As we go to press, statistical analysis website FiveThirtyEight gives Democrats a 53% chance of retaining control of the Senate. And it projects Republicans have an 82% chance of capturing the House.

A divided government might stunt political progress, but it's great for investors. That's because Congress won't be able to change much in terms of policy... specifically, tax policy.

There are two key variables to consider when you think about market valuations...

The first is inflation, which we talked about two weeks ago. The other is taxes.

Taxes directly affect how much money from your investments actually makes it into your pocket. So any change to the tax rate will also change how investors value the market.

Higher taxes lead to lower gains. Investors have historically had a more pessimistic view of the market when taxes are high.

We can see this through the S&P 500's price-to-earnings (P/E) ratio.

The P/E ratio tells us the relationship between a company's stock price and its earnings per share. It's a way of determining how much extra an investor is willing to spend on a stock compared to earnings.

P/E multiples tend to rise in times of market optimism because investors are confident that valuations will keep climbing. But when market sentiment sours – as it does when taxes increase – P/E multiples usually fall.

Take a look...

Right now, taxes are relatively low...

The current combined dividend and capital gains tax levels are some of the lowest in history. Plus, inflation rates are expected to fall below 3% in the next five to 10 years. In the current environment, we'd expect a P/E multiple of about 20 times (it sits at 18 times today).

We've written at length about how these valuations could fall if inflation continues to creep higher. The same could happen if taxes jump.

A Democrat-controlled government with sizable majorities (which we don't currently have) might mean higher taxes.

But if the election results in a split government, that probably won't happen. Republicans will likely argue for lower taxes while Democrats fight to raise them. In the end, taxes will go nowhere.

And as long as taxes stay where they are and the Fed can calm inflation, market valuations should stay high.

Keep a close eye on the election results. They can tell you a lot about what's to come for the market.

Regards,

Joel Litman
October 31, 2022