Why the Midterm Elections Matter for the Stock Market This Year

Midterm elections could have a bigger impact on the stock market this year. . (KAMIL KRZACZYNSKI / AFP / Getty Images)

U.S. midterm elections are right around the corner, and they may pose a threat to the driving force behind the bull market—the AI trade.

In the lead up to the midterms, which are slated for Nov. 3, the stock market has proven quite resilient. The S&P 500 has bucked the September Effect, staying positive month-to-date. This strength comes in the face of historic Treasury yields, high oil prices, and a interest-rate hike from the Federal Reserve during a relatively quiet period in between earnings seasons. And its largely driven by strength in the tech sector. The Technology Select Sector SPDR ETF has gained 4.3% this month, while the S&P 500 was roughly flat.

But these elections could prove to be critical for continued tech strength. The sector has largely driven by optimism around artificial intelligence, but the election has the potential to stop the momentum. Anti-AI sentiment has been driving some local and state election races, and could lead to legislation that threatens the AI expansion. That would be detrimental to the S&P 500, where a few AI stocks have done the heavy lifting while a stealth bear market hides beneath the surface of an index trading near record highs.

Midterms are usually not something for investors to worry about. Yes, the political noises can drives volatility, but rarely do they have a long-term impact on market direction. The Cboe Volatility Index averages above 20 in election years compared with below 19 in nonelection years, according to Dow Jones Market Data going back to 1990. Equities, though, tend to move higher regardless of the outcome of midterm elections.

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In fact, the S&P 500 has averaged double-digit gains going back to 1933 whether there’s a unified government, a split Congress, or a unified Congress with a president of a different party, per research from Capital Group. The index has seen positive returns in the year after a midterm election in 95% of instances dating back to 1950, data from Fidelity show.

This time may be different. Baird investment strategist Ross Mayfield says he’s watching the midterms more closely than he has in previous election cycles as an indicator of what’s to come for the AI trade.

“The biggest risk to the market from the midterms is that there’s enough anti-data center pushback at the local and state level to result in a slowdown or a delay of projects that a lot of the bull market is built on,” he says. Baird likens AI’s current PR crisis to the negative reputation the fracking industry had last decade.

He says that more red tape for AI data centers could weigh on hyperscaler profitability and run downstream to the stocks that have been the winners of the AI trade in recent years, including chip makers , energy names , memory plays , and data REITs.

There is certainly no shortage of anti-data center sentiment ahead of the election. In fact, it’s an issue Americans across demographic groups and political affiliations are united on.

Roughly half of Americans view data centers as “mostly bad” for the environment (54%), home energy costs (50%), and the quality of life of the people living nearby (49%), recent survey results from Pew Research showed.

That’s a significant uptick in negative sentiment around data centers compared with the start of the year. It’s also important to note that Pew’s most recent polling was conducted before AI leaders issued dire warnings about the potential dangers of the tech.

“Right now, affordability is a key issue and the easy scapegoat here is going to continue to be an AI capex spend and putting it on a pedestal [as] the main reason for affordability problems,” David Wagner Aptus Capital Investments’ head of equities says.

Wagner adds he doesn’t expect anti-AI worries to derail capex spending or the AI trade itself, but they could pose a sentiment issue that could ultimately weigh on the stocks.

Mayfield holds a similar view, saying this regulation would be “annoying,” not “fatal” for hyperscalers, though it would weigh on profits.

Margin compression driven by higher costs associated with local and state legislation would be a change that shareholders wouldn’t love, but it becomes a larger issue when considering the market concentration of the impacted stocks.

Goldman Sachs’ equity strategy team said in a note published on Monday that AI strength has fueled S&P 500 resilience despite the median stock in the index trading 16% from its 52-week high. They noted market breadth is at its lowest level since the dot-com bubble. Anti-AI regulatory changes that could come out of midterms could drag AI stocks down, and reveal that broader market weakness.

For once, the election noise might not be something to tune out.

Write to Naomi Buchanan at naomi.buchanan@barrons.com.

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