KEY TAKEAWAYS
- Stocks tend to sell off ahead of the midterm elections.
- There is pronounced market volatility immediately before and after midterm elections.
- Stock markets tend to bounce higher in the two quarters after the midterm elections.
When it comes to stock market performance, midterm election years aren’t like other years.
Take 2018, when Democrats regained control of the House of Representatives. The GOP had just pushed through a massive package of tax cuts, and the unemployment rate finished the year below 4%. Consumer confidence had risen to a post-Great Recession high, with business investment on the rise.
You’d think that scenario would lead to a booming stock market, but that’s not what happened. Instead, stocks dropped 6.2% in 2018 as the Federal Reserve raised interest rates four times and the U.S. started a trade war with China.
History shows that market performance during the midterm election year of 2018 is hardly an anomaly. In fact, the second year of a presidential term follows a predictable pattern: average stocks returns tend to dip in the second and third quarters, with elevated market volatility, followed by a stock market rebound by the end of the year and into the first half of the following year.
“In the short term, midterm elections affect client portfolios,” said Tyler Ozanne, a financial advisor with Probity Advisors. Let’s take a closer look at how this plays out.
Stock Markets Tend to Drop Before Midterm Elections
“It has been long and painful and depressing.” That was how Joseph Liro, an economist at Stone & McCarthy Research Associates, described the stock market’s performance to the New York Times after the third quarter of 2002, a midterm election year.
His foul mood was justified: After barely moving in the first three months of 2002, the total return of the S&P 500 dropped 13% over the next three months, and then another 17% after that.
Corporate profits suffered, consumer spending was uninspired and international stocks, especially in Japan and Europe, further dragged down risk appetite. Meanwhile, there was anxiety over an imminent war in Iraq, one of the world’s leading crude oil producers.
While market performance is seldom this dramatic during midterm election years, data show that you shouldn’t be surprised when stocks falter in the leadup to the polls, according to data from Sam Stovall, chief investment strategist at CFRA.
“I call the mid-term election year the ‘sophomore slump’ for the president,” Stovall told Forbes Advisor.
The midterms take place in the third quarter of the second year of a presidential term. According to Stovall’s data, in midterm election years between 1945 and 2021, stocks saw an average decline of 1.8% in the second quarter and drop another 0.5% in the third quarter.
Interestingly, these are the only two quarters that have experienced an average price decline in the past 76 years, according to Stovall.
Any number of trends have already been established for history to repeat itself, not least of which is Russia’s invasion of Ukraine and the Fed’s impending rate increases.
Midterm Election Years Tend to See Heightened Market Volatility
Investors should prepare themselves for a bumpy ride in the quarters before and after the midterm elections.
The midterm election year of 2022 got off to a challenging start for markets thanks to prospective interest rate hikes by the Fed, which has dented demand for the big tech stocks that dominated the post-Covid lockdown recovery. This has caused some investors to fear an overall slowing of the economy as the Fed tries to tame high inflation.
With stocks coming into the year trading at expensive valuations, it’s not surprising to see them jump around when bad news—a bad earnings report, international conflict—pops onto the radar.
Historically stock markets have swung wildly in midterm election years, and just like poor returns, stocks have been most volatile in the second and third quarters of a midterm election year.
An analysis by the financial services giant Capital Group found that stocks had a median standard deviation of return of 15% since 1970, which is two percentage points higher than in all other years.
“The volatility in presidential election years was very similar to non-election years, indicating that midterm elections truly were the outlier,” reads a Capital Group report.
This trend came into stark relief when the Dow Jones Industrial Average (DJIA) plunged roughly 1,000 points on May 7, 2010, before rebounding to close down by almost 350 points, or more than 3%. During that midterm election year, a major debt crisis in Europe saw the International Monetary Fund (IMF) bail out the Greek government, which was drowning in bad debt, punishing the European economy.
Stock Markets Tend to Rebound after the Midterm Elections
After trying spells before midterm elections, the stock market tends to calm down and convalesce for months afterward.
Stovall’s data finds that the S&P 500 returns 6.1% in the fourth quarter of election years, then delivers a 7.5% gain in the first quarter and 4.2% in the second quarter of the following year. Investors spend much of the midterm election news cycle worried about the outcome, and then relax when they discover the world hasn’t ended after the election.
These findings aren’t random, either. A study published in the Spring 2019 edition of the Journal of Wealth Management found that, “by examining the quarterly total 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.”
Moreover, the study found that neither changes by the Federal Reserve or spending by Congress could account for the effect.
In 1990, stocks fell nearly 14% over the summer as the nation struggled with a recession, high unemployment and a painful oil shock. The first Gulf War was commencing and consumers were losing confidence.
Just three months later, though, stocks rose 8.5% and then jumped another 15% in the three months after that. The Dow Jones Industrial Advantage hit 3,000 soon thereafter. Investors were buoyed by the Federal Reserve cutting interest rates to help get the economy back on track.
What to Watch in the 2022 Midterm Election
This year’s trends in politics and the economy are sending conflicting signals. Democratic political candidates and economists have been singing the economy’s praises for much of the past year. The unemployment rate is down, employers are adding jobs and workers are finally getting big raises.
Economic growth has been robust, even with the Omicron variant of Covid-19, so much so that the Federal Reserve will almost certainly raise rates this spring.
At the same time, Republican candidates have hammered away at runaway inflation as one of their major talking points, with price increases running at four-decade highs. Many Americans are spending more than they’re used to at the grocery store, gas tank and on electric bills; in fact, the average worker has seen their pay rise less than prices overall.
That’s why consumer sentiment about the economy, especially in the most recent Forbes Advisor-Ipsos Consumer Confidence poll, looks so weak.
Toss in four or five Fed potential interest rate hikes, slowing economic growth and continued supply chain shortages, and it’s no surprise that Americans are feeling so rotten.
These blues, according to a recent piece by Paul Whiteley and Harold Clarke in the London School of Economics website, could lead to the party out of power—the Republicans—winning enough elections to gain a majority in the House of Representatives, and perhaps even in the Senate.
Should that occur, any faint hope that President Biden has in rekindling interest in his Build Back Better plan will be all but extinguished, while Congress could pivot to issues that have bipartisan support, like retirement policy and …….
How Should You Position Your Portfolio?
Each midterm election, though, comes with its own peculiarities. While stocks did fall in 2018, much of that decline took place at the end of the year, which is why you shouldn’t rely on historical trends in an attempt to time the market.
Ozanne said he’s getting more calls than usual from clients asking about this year’s midterms, which he attributes to concern about potentially higher taxes should Democrats remain in power.
He cautions, though, that while investors need to be sensitive to potential gyrations in stocks and bonds during midterm election years, you should hold steady to avoid making rash decisions before November.
“We’re talking about a period of weeks and months,” said Ozanne. “Over the long term, midterm elections have no bearing on investment portfolios.”
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