Market Insider

Why Wall Street has not priced in the midterm elections

What Election Day means for stocks

The midterm elections, which Wall Street has largely ignored, could pack some surprises for markets Tuesday.

That however, would be against the conventional view—which is that the election is largely inconsequential, and that the 2016 presidential election is far more important. The entire House of Representatives and 36 Senate seats are on the ballot.

This year the Senate is in play, with Republicans hoping to garner a majority of seats but unlikely to gain the supermajority of 60 percent that would allow them to override a variety of procedural hurdles and run with legislation opposed by Democrats.

But it would give Republicans control of both houses and with a Democratic president, that is seen by some on Wall Street as a recipe for gridlock—which in itself is seen as a plus for markets. Strategists say that some investors see that type of situation as similar to the current dysfunction in Congress, and that is one reason why the market has not yet fully priced in the potential for change.

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"I have never seen such lack of attention on the part of investors toward a U.S. election," said Dan Clifton, head of political strategy at Strategas. "I think (Republican Senate majority) is the consensus in peoples' minds. I just don't think anyone's put money to work because of it."

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The election may not be that cut and dry either. "There's probably a greater than 50 percent probability that we do not know who the winner of the Senate is 24 hours after election day. That's where your volatility will come from," he said. Clifton noted there are several states that are a close call, including Louisiana which does not have a runoff election until Dec. 6.

Clifton said a Republican win would be positive for stocks and also sectors where they could make an impact, like energy, defense and medical devices. The more Republican seats gained above 51, the better for stocks, he added.

Greg Valliere, chief political strategist at Potomac Research Group, said the odds favor the Republicans taking control, but it could be close. "I think chances are 60-65 percent they take the Senate by just one. It's hard to say this is a sweepingly good story for the market. I think if the Republicans have a poor night, it would be a negative for the markets," he said.

Tax reform is one issue that would be immediately discussed. "The biggest issue you're going to hear a lot about in the next several months is going to be tax reform. If Republicans have a great night Tuesday, and when they meet the press Wednesday, they'll talk their agenda—tax reform, regulatory reform. Those things would be high on their list," Valliere said.

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But he said there will be disagreement, as President Barack Obama would like to generate more revenue as part of tax reform, and House Republicans have made it clear they want it to be tax neutral.

"I think one reason why people are not saying this is a huge event is because you still have the Obama veto pen, executive authority pen," said Valliere. "To override the veto, you need 67 votes in the Senate, and if the Republicans vote to kill Obamacare for the millionth time, he'll veto it. So on a lot of big issues, the president has a lot of authority and you need 60 votes to get something big through the Senate."

South Dakota, Montana and West Virginia are expected to go Republican, while Alaska, Arkansas and Louisiana also are leaning that way but look a little more shaky, Valliere said. Louisiana may need a runoff and other states that are very close are New Hampshire, Iowa, Colorado and North Carolina.

"If Colorado falls, it's going to be hard for the Dems to keep the Senate," said Valliere, noting Republican Cory Gardner is moving into the lead there. "If (Sen.) Jeanne Shaheen (D-N.H.) loses or it looks 50-50 in New Hampshire, that would be an early sign on Tuesday night for the Democrats," he said.

Strategists are clearly at odds over how much of the anticipated election outcome is already priced in to a stock market that has seen huge volatility in the weeks running up to the vote. With the fixation on the end of Fed bond buying, the Ebola scare and fears about the global economy, the election was little mentioned by most analysts and traders.

Leo Grohowski, CIO of BNY Mellon Wealth Management, said the election is fairly low on the list of things investors are talking about. "Our view is there's about a 70 percent probability of a Republican takeover of the Senate priced into the market, and if that doesn't happen, I think the downside for the market the day after the election is greater than what the upside would be if in fact they do take the Senate," he said.

But he added any volatility would likely be limited. "The outcome next Tuesday just doesn't change our year-end forecast. I just don't think it will be a big market mover," Grohowski said. He expects to see the S&P 500 at current levels—at about 2,000 at year-end, and 2,200 by the end of 2015.

Strategists expect the Keystone pipeline to get a push in Congress if Republicans win the Senate. The administration has held off approval of the controversial pipeline which would take Canadian crude to the refineries on the Gulf Coast.

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Secretary of State John Kerry said he wanted a decision on the pipeline "sooner rather than later" during a visit to Canada this week. The State Department is awaiting the results of a court challenge on the line's route through Nebraska and its own study before making a final recommendation to the president.

"The energy stocks could benefit just on the perception they could move quickly on Keystone," Valliere said. "The coal industry would be extremely happy to have Mitch McConnell back. If he's the Senate majority leader, that would be a good story for the coal industry."

Republicans would also favor natural gas and oil exports, so that would be a positive for a range of energy stocks.

Clifton said energy and other stocks could gain on the prospect that Obama could succeed in getting a new Pacific trade deal, which is opposed by some Democrats. That could allow U.S. energy exports, like liquefied natural gas and ultimately even oil, to flow into new markets in Asia.

While it's unlikely Obamacare would be voted out, it could be changed. "There's a good chance the Republicans could kill the device tax. A lot of Democrats don't like the device tax," Valliere said. Elimination of the 2.3 percent tax on sales of medical devices, as part of the Affordable Care Act, could help stocks of the medical device makers, he said.

Defense stocks may also benefit. "With Republicans in control of everything they may succeed in killing the budget sequester for the Pentagon," Valliere said.

Valliere said there's also a thawing attitude about austerity in Washington, and Congress may be more in a mood to spend, as the deficit narrows. That was seen in third-quarter GDP, which got a big boost from government spending. "I think we're entering a period where government spending is going to be a contributor to GDP, rather than a drag," he said.