Bank of America strategist Hartnett believes the market is pricing in the midterm elections with excessive optimism, warning that a Democratic takeover of the Senate could expose U.S. stocks to a correction risk of more than 10%.

Current market valuations are built on the assumption of a moderate midterm outcome, with continued deregulation and AI-friendly policies. In a research note released on August 23, Hartnett argued this assumption may be fundamentally flawed.

He stated that if Democrats secure the Senate, two core market narratives would face simultaneous shocks: financial deregulation and political support for AI capital expenditure. Combined, these factors could drive a more than 10% market correction before year-end, accompanied by a weaker U.S. dollar and declining bond yields.

Political fundamentals are already deteriorating

According to Bank of America data, Trump's current overall approval rating stands at 39%, with economic approval at just 36% and inflation approval even lower at 30% — all significantly below the levels seen before the Iran conflict.

This suggests the Republican base entering the November elections is not as solid as assumed. Hartnett's hedging strategy is built precisely on this political reality that the market has largely overlooked.

The Texas race: a referendum on AI policy

Hartnett specifically highlighted the unique significance of the Texas gubernatorial election.

In his view, this race is evolving into a referendum on the "electricity costs and affordability" of AI infrastructure. The rapid expansion of AI data centers has created massive electricity consumption and infrastructure strain, which has already triggered political backlash in Texas.

Should a Democrat achieve an upset victory in Texas, the market would be forced to reassess whether AI capital expenditure can continue to receive unconditional political backing.

This is not merely a political signal — it directly undermines the market's pricing logic for AI hyper-scale investment.

Two hedging paths: financials and semiconductors

Hartnett outlined specific hedging instruments.

Financial stocks (XLF): XLF remains within an upward trend channel, with key support near $56, where the 50-day moving average also converges. Hartnett recommends expressing a bearish view through November-expiring put spreads — specifically the Nov 56/52 put spread, offering a maximum payout ratio of approximately 4 times.

Semiconductor ETF (SMH): The semiconductor sector lost momentum at the end of June and has continued to underperform the broader market. The latest rebound was again rejected at the 50-day moving average and the short-term downtrend line, with long-term support still near the 200-day moving average, a considerable distance from current prices.

Critically, semiconductor volatility has declined substantially over the past few weeks, making hedging costs more attractive. Hartnett suggests using SMH downside option structures to protect against this risk.

Fund flows are already confirming the trend

Flow data provides supporting evidence.

According to Bank of America data, semiconductor ETFs have seen cumulative outflows of approximately $6 billion over the past three weeks. Hartnett noted this may not be a targeted hedge against the midterm elections, "but fund flows are moving in the direction of the bearish scenario."

Hartnett also presented a second logical pathway — with a different catalyst, but reaching the same conclusion.

He argues that quantitative easing (QE) marked the starting point of the 20-year bull market and gave rise to Wall Street's "too big to fail" narrative. After two decades of extraordinary monetary stimulus, the market broadly expects the current "repairing fixed income" policy efforts to succeed.

However, if Treasury Secretary Bessent fails to push the 30-year Treasury yield below 5%, Hartnett believes policy failure would drive a weaker dollar and trigger a market shift: shorting risk assets, shorting leverage — especially AI hyper-scale operators and private credit — and shorting cyclical sectors such as financials.

"Different catalysts, same hedge: financials and AI," Hartnett concluded.