Here’s why the stock market is rallying even though the election outcome is still uncertain

The lack of a blue wave makes higher taxes and more regulation less likely, and that’s enough to rally stocks for now.

The election outcome is in no way clear as states continue to count ballots. There is no decision on the presidency, but traders are betting on a split Congress with a Republican Senate and Democratic House. Some Senate races were still uncalled Wednesday, and several key states were still counting votes and too close to call.

Stocks bounced higher Wednesday, led by the Nasdaq which rose 4% as big tech, like Amazon and Apple surged. Bond yields fell, as investors bought bonds as a hedge against uncertainty and also as a big stimulus package looks far less likely.

The typically subdued Treasury market was also volatile. The yield on the benchmark 10-year ran up to 0.94% Tuesday night on early expectations of a blue wave, or Democratic sweep, but reversed sharply and fell to 0.75% Wednesday. Rates had been rising on the expectations that a big stimulus package from Democrats could result in much more government debt and inflation.

“You see the 10-year yield is down quite a bit, Nasdaq is up quite a bit. The low interest rates, growth stock oriented market, at least for today, is still in tact,” said Ed Keon, chief investment strategist at QMA.

The question is, however, at what point would markets be impacted if the election is contested over a long period, and there is an environment of acrimony that stretches from weeks into months.

Going into the election the NBC News/Wall Street Journal poll showed Democrat Joe Biden ahead of President Donald Trump by 10 percentage points. Polls had also showed the potential for Democrats to claim victory in a number of tight Senate races that could give them a majority.

Biden was leading slightly Wednesday in the electoral college, but votes were still being counted in key states, including Pennsylvania. Both Biden and Trump have said they are confident they are winning.

Before the election, some investors had been betting on a ‘blue wave,’ with the focus on the prospect of a huge stimulus program that would have boosted value stocks, small caps, and alternate energy.

Big tech had been under pressure, amid concerns of stiffer regulation and higher taxes. Health care also lagged on worries Democrats would expand the Affordable Care Act, and there was concern Democrats would approve regulations that could limit fracking.

But those ‘blue wave’ trades reversed Wednesday, with health care surging 5.7%, and technology jumping 4%. Communications services, which includes Facebook and Alphabet, rose 5%, and consumer discretionary stocks rose 3.9%.

Two sectors helped by infrastructure spending lagged. Industrials were up just 0.8% and materials were down 0.3%.

“It seems like the market will go up regardless of who wins [the White House], but it will go up for different reasons,” said Sam Stovall, chief investment strategist at CFRA. “Technology will do better if the threat of regulation and breakup is dissolved, whereas industrials and materials might do better if there’s going to be economic stimulus with infrastructure spending.”

Stovall said the keys to Wednesday’s rally were relief that it’s unlikely Democrats will raise taxes and impose new regulations. Biden had said he would undue the corporate tax cut Republicans approved in 2017 that took the corporate tax rate to 21%. Biden said he would raise that rate to 28% and also raise the capital gains tax and taxes for wealthy individuals.

In 2016, stocks surged when Donald Trump won the presidency on his tax and economic policies, despite conventional thinking that the market could crash if he beat Hilary Clinton. Now that his re-election is uncertain, stocks are again higher, despite expectations an unclear election result would hurt the stock market.

“It’s a complicated mix of things but the bottom line is the market is moving higher on this mix of reduced uncertainty and a better tax environment and that seems to be enough to offset the concern about a contested election,” said Keon.

But the bond market is less optimistic.

“Let’s say it’s a multiple week delay…I’d say yields would be much lower. If it’s a couple week delay, the 10-year is probably below 0.60%,” said Michael Schumacher, director of rates strategy at Wells Fargo.

Schumacher said if Biden is president with a Republican Senate, that is the election scenario that would likely lead to the least amount of stimulus spending. The bond market is already reflecting concerns that less stimulus could impact growth, but stocks Wednesday didn’t appear to share that sentiment.

“The election is not out of the woods yet. The market needs to take a breather and let it play out a little bit,” said Schumacher.

Wharton School professor Jeremy Siegel said if Biden wins, it could be a positive, even if Trump’s presidency has been good for the economy and stocks.

“This is good for the stock market,” said Siegel, on CNBC. “The tax increase was a big potential negative that is off the table.”

Siegel said if Biden is the winner he may actually work better with Senate Majority Leader Mitch McConnell because of his reputation of working across the aisle, and he would also have a different approach to trade relations. Siegel said many of Trump’s policies were positive but his trade war was not one of them.

The markets have been repeatedly disappointed by a lack of a stimulus deal, so that was one Democratic policy that had viewed as positive by the stock market. The White House had been working out a compromise with House Democrats towards a large $2 trillion stimulus proposal, but the effort stalled ahead of the election. Senate Republicans sought a much smaller package.

McConnell said Wednesday that a new Covid stimulus package would be needed by the end of the year, suggesting Congress and the White House could work on a bill in the lame duck session.

But there is also a concern that a Biden presidency with a split Congress could end up in gridlock. Stocks have historically performed better when a president has a Congress dominated by his own party, as Trump did early in his term when the tax law was changed.

“92 years worth of data show that in divided government years, the average return is 6.1% versus unified government years at 9.3%,” said Julian Emanuel, head of equities and derivatives strategy at BTIG. “Who is president matters to the process itself. Maintaining the integrity of the voting and counting process and the decision of one part or the other to concede and that happening sooner rather than later is important.”

Emanuel said he expects the correction that started on Sept. 2 has some ways to go, with stocks still more than halfway back to prior levels. The pandemic is continuing to spread, and if it begins to impact the economy again, stocks would struggle.

“Investors have incorrectly gotten comfortable with the dichotomy between the stock market and the real economy,” Emanuel said. But he also said a major incentive for stock investors is the fact the interest rates are very low.

“The message of the bond market today is that higher rates can happen, but it is going to be a long slog,” Emanuel said.