Stock performance and midterm elections share a peculiar relationship. As midterm elections approach, markets turn volatile. Staying true to the pattern, the market has witnessed peaks and troughs in the past few weeks. In the short term, midterm elections do impact investor portfolios. Here are the four things investors should know in light of another midterm election on the horizon.
1. The Stock Market Usually Dips Before a Midterm Election
Historically, markets have performed the worst during midterm election years. After the continued drop in returns in the third quarter of 2002 (a midterm year), Joseph Liro, the 30-year-old market veteran and an economist with Stone & McCarthy Research Associates, told the New York Times, “It has been long and painful and depressing.”1 He was commenting on the diminishing returns on the S&P 500, which remained stagnant for the first quarter, dropped 13% over the next 3 months, and then dropped another 17% in the third quarter.
Another study reiterates this trend. It showed that S&P 500 registers an average decline of 19% in the months leading up to midterm elections.2
Multiple factors contribute to market movements. The most significant factor this year has been the stress over inflation and the Federal Reserve’s response to inflation. However, midterms introduce uncertainty to the multivariate equation, and markets are most sensitive to uncertainty. With the fate of the Federal government in question, market pundits cannot make reasonable predictions about the future, which sends the market into a tailspin.
2. Fresh Momentum After Midterm Elections
The trough before a midterm election is followed by a peak after it. After the 19% fall, the S&P 500 usually rallied for a year after the midterm, averaging around 32%.3 It has followed the same trend after every midterm election since 1942.
Another study published in the Journal of Wealth Management discovered, “by examining the total quarterly returns on the S&P 500 Index between 1954 and 2017, [the authors] show that, nine times out of 10, the index has been positive in the fourth quarter of a midterm election year and the following two quarters.”4
As uncertainty begins to fizzle, market participants have more information about the party in power, their agenda, and future policy direction. Evidently, it does not matter who wins as long as the market knows what to expect of the winner. Uncertainty brings the markets down, and a semblance of certainty pushes them up.
Another important factor to consider here is the threat of recession. On most years after the midterm, there is a negligible probability of a recession. However, like the late 1960s and 1970s, 2023 faces rising energy costs and slow economic growth. To counter a looming recession, the Fed has been incrementally raising lending rates to control inflation without hampering economic growth. These measures have had minimal effects. If the Fed continues to increase rates, the threat of recession becomes stronger, which introduces more unpredictably into the markets.
It is important to note that a recession does not equate to bad stock returns. The market runs on the expectation of future events. So, if the market has already factored in the threat of a recession, it may soar on the prospect of future good news.
3. Markets Don’t React to Who Controls Washington
Politics is divisive. It is easy to develop a biased mindset that entertains the notion that markets perform better under Republicans or Democrats. However, unlike humans, markets do not favor a party. Data suggests that markets soar after an election, irrespective of the party in power.5
Markets are affected by corporate earnings, interest rates, supply & demand dynamics, housing prices, inflation, employment, and many other micro- and macro-economic factors. While governments may influence these factors, their composition does not appear to matter for the markets. Moreover, changes in the composition of the government have no impact on the daily movement of the markets. The S&P rises after the midterm elections in anticipation of certainty and not because of the winning party.
At the time of writing, polls suggest that Republicans are favored in the House and Democrats are slightly favored in the Senate. The split predictions suggest a Congressional gridlock. It is interesting to note that markets favor gridlocks. After all, gridlocks represent the maintenance of the status quo regarding economic policy.6
4. Investment Decisions Should Not Be Rooted in Politics
Decisions about financial investment cannot be influenced by political leaning. Buying or selling stocks depending on predictions of who might win the election is not an investment strategy; it is speculation at best. Given how effective politics is in drawing a line in the sand, it is difficult to separate politics from investment decisions. However, investors have missed the longest bull markets because they did not like President Barack Obama7 or agreed with President Donald Trump.8 Investments should be goal-oriented and not influenced by politics.
Recognize The Drivers Of Your Investment Portfolio
New developments in the market always attract investor attention and trigger market movement. Similarly, midterm elections impact the markets. However, investors should not make changes to their investment decisions based on who wins. They should observe trends, study their impact, and understand how it influences the industries that matter to them.
1) New York Times, September 30, 2002
2) CNN Business, October 6, 2022
3) Forbes, October 2, 2022
4) The Journal of Wealth Management, Spring 2019
5) Forbes, January 12, 2021
6) FiveThirtyEight, November 2, 2022
7) The White House | President Barack Obama, January 9, 2017
8) CNN Business, January 20, 2021