Will stock market launch Republicans to victory?

Will stock market launch Republicans to victory?
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In 1992, James Carville famously coined the phrase “it’s the economy, stupid” to focus attention on the prevailing recession at the time in order to help Bill ClintonWilliam (Bill) Jefferson ClintonTrump, GOP regain edge in Kavanaugh battle Presidential approval: It's the economy; except when it's not Hypocrisy in Kavanaugh case enough to set off alarms in DC MORE successfully unseat George H.W. Bush. If it really is all about the economy, the current environment of accelerating growth and unemployment at historically low rates should have the Republicans feeling pretty good about their chances in the midterm elections.

Fairly or unfairly, the party in power generally gets the lion’s share of the benefit when things are going well and the blame when things are going poorly. Supporters of Barack ObamaBarack Hussein ObamaFord taps Obama, Clinton alum to navigate Senate hearing McCaskill to oppose Kavanaugh nomination Presidential approval: It's the economy; except when it's not MORE rightly contend that Donald Trump inherited an improving economy, and supporters of Trump point to positive economic trends since his election. The truth of who is actually responsible for economic performance likely lies somewhere in between.

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The stock market is a reflection of the economy, albeit an imperfect one. Most importantly, it is most often a forward looking reflection of the economy, and it certainly appears as to be a tailwind for Trump and the Republicans.

As a value investor, I focus on earnings and the price to earnings ratio of both individual stocks in the market and the price to earnings ratio of the market as a whole. Many investors and pundits jump to the conclusion that by traditional measures, the stock market is wildly overvalued on a price to earnings basis and that a stock market correction or even a crash is imminent. They cite the fact that the S&P 500 index is selling at a price earnings ratio of 25 times, compared to an historical mean of 15 times, trailing over the past year.

I take issue with that simplistic assessment and believe that current valuation levels are still quite favorable to stocks, particularly over bonds. The 10-year Treasury bond is yielding less than 3 percent, which means that it is essentially selling at a price earnings ratio of nearly 35 times earnings. Moreover, those “earnings” that a purchaser of the 10-year bond is entitled to do not grow.

The stock market is forward looking, and the S&P 500 index sells at a price to earnings ratio of around 17 times on a forward looking basis over the next year. That ratio is actually slightly down from last quarter, and substantially down from around 19 times a year ago. In essence, on a forward price to earnings basis, the stock market has recently gotten less, not more, expensive. Many analysts focus too much on the “price” part of the equation and ignore that earnings growth has accelerated.

Now, the attractiveness of stocks overall, and stocks relative to bonds, declines as interest rates rise, and rapidly rising interest rates could derail stock market growth. This is why President TrumpDonald John TrumpTrump rallies in Nevada amid Supreme Court flurry: 'We're gonna get Brett' Trump: 'Good news' that Obama is campaigning again Trump boosts Heller, hammers 'Wacky Jacky' opponent in Nevada MORE has been publicly critical of Federal Reserve Chairman Jerome Powell’s policy of slowly raising interest rates. The overwhelming consensus of the market is that interest rates are going to continue to rise over the foreseeable future, but only at a very measured pace. It is likely that Fed will raise the target federal funds rate by 0.25 percentage points at its meeting next month. There is also a good chance that the Fed will again raise the target fed funds rates by another 0.25 percentage points in December.

So with the economy humming along and, if it really is “the economy, stupid,” will Republicans prevail in the midterm elections? There may be an even stronger wind blowing than the economy. Parties in power most often lose ground in the midterms. A reflection perhaps of buyer’s remorse from the previous election, the deck is generally stacked against the incumbent party. Since 1934, in 21 midterm elections, the incumbent party has lost an average of 27 House seats and nearly four Senate seats.

Furthermore, incumbents have only gained House seats in three elections and Senate seats in five elections. This November, the underlying economy, as reflected by the stock market, will certainly be a tailwind. But for Republicans, the headwind of history may prove to be even stronger.

Robert R. Johnson is a professor at the Heider College of Business at Creighton University, principal at Fed Policy Investment Research Group, and an author of “Strategic Value Investing” and “Invest with the Fed.”