Why it looks like the stock market wants the Democrats to keep control of the U.S. Senate

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Many investors believe that Wall Street favors Republicans over Democrats. But try telling that to the U.S. stock market over the past 12 months. As you can see from the chart below, the S&P 500
SPX,
-0.80%

has tended to rise and fall in fairly close correlation with the odds that the Democrats will retain control of the U.S. Senate after the midterm elections in November. (These odds are based on the pricing of the Smarkets electronic futures contract tied to post midterm U.S. Senate control.)

Eyeballing a chart can be an unreliable guide. So I also measured the correlation coefficient between percentage changes of the S&P 500 and the Smarkets contract over all rolling one- and two-week periods over the past 12 months. The correlations were positive and significant at the 95% confidence level that statisticians use when determining if a pattern is more than a fluke.

Does this mean Wall Street is actually rooting for the Democrats to retain control of the Senate? Not necessarily, according to to Eric Zitzewitz, an economics professor at Dartmouth College who two decades ago pioneered the use of electronic betting markets to gain insight into the markets’ behavior.

What more likely is going on, he said in an email, is a third factor that is itself correlated with both the stock market and the Democratic Party’s chances of retaining control of the Senate.

That third variable is almost certainly the U.S. economy, since good economic news will improve both the stock market as well as the Democrats’ chances of retaining control of the Senate. During July and August, for example, when it looked to many as though inflation had peaked, the Democrats’ Senate-control odds improved and the stock market rallied. Since the beginning of September, in contrast, as the news on the inflation front has worsened, both the Democrats’ odds and the stock market have declined.

What’s important to note about Zitzewitz’s hypothesis is that an improved economy helps the incumbent party, regardless of which party that is. In past election cycles when the Republicans were the incumbent, for example, a strong economy made it look like the stock market preferred Republicans over Democrats — just the opposite what the correlations suggest this time around.

According to Professor Zitzewitz: This indicates “how tied the Democrats’ fortunes are to the economy, as opposed to a prediction that their retaining power would be good for asset values.”

Or, as Democratic strategist James Carville famously said about Bill Clinton’s campaign for president: “It’s the economy, stupid.”

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com

More: Midterm elections: Republican edge over Democrats in one key indicator rises to 4-month high

Plus: As Democrats and Republicans battle for younger voters, one side is outspending the other 3-to-1



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