Markets Could Go on a Tear After the Midterms, History Suggests

Stovall has been tracking market trends for more than four decades, spending much of that time as the chief market strategist at Standard & Poors. In late October, Stovall and several colleagues at CFRA hosted a market outlook webinar that focused on the road ahead for equity markets, using the lens of the coming midterm elections to frame possible returns. 

No longer a freshman, not yet a junior. Thus far in 2022, market returns are playing out right in line with historical trends. In the second year of a presidential cycle, equity markets typically lose ground in the second and third quarters, notes Stovall. The 20.9% plunge in the S&P 500 across the past two quarters surely fits the trend of a sophomore slump.

Yet the fourth quarter of the second year has historically signaled a turning point. Equity markets have risen 84% of the time, with an average gain of 6.4% for the S&P 500. Over a 12-month forward basis (through the end of the third quarter of year three), the average gain stands at 21.9%. (The large-cap index is up around 5% thus far in the fourth quarter of 2022.) 

Note that those time frames coincide with midterm elections. Stovall’s research shows that regardless of the outcome of the election, advisors have reason to expect a rebound. Studying data going back to 1945, Stovall says that markets have rallied in the 12 months after elections 75% of the time when one party has been able to control all three branches of government. But when the GOP has retaken the House, Senate, or both chambers after having been the minority party in the chamber(s) going into the race, markets have managed to rise 71% of the time. “Gridlock is good, but unity is better,” concludes Stovall. 

Indeed, Stovall says the timing of a market reversal may be at hand. Through five midterm cycles when stocks were in a bear market, “October represented a market bottom 80% of the time, adding that “there are no guarantees, but this certainly offers encouragement to investors.”

Where have market gains been most sharply focused? CFRA research has found that information technology stocks have been the strongest gainers, rising on every occasion in year three of a Presidential cycle, with an average gain of 29.9%. There is a potential symmetry in place here. Tech stocks have fallen 29% over the past 12 months. In year three of the cycle, healthcare and consumer discretionary stocks have gone on to post average gains of nearly 20%.

Stovall thinks investors exhale once voters have gone to the polls. “Markets rally when the uncertainty around elections is behind us,” he says. And he adds another important caveat: “Don’t try and wait for a specific ‘turning issue’ before becoming bullish.” Investors will surely welcome any signs of calming in equity and bond markets. In a recent note to clients, Stovall wrote that “returns prior to midterm election years have traditionally been volatile,” yet he adds that volatility has fallen, on average, by 28% in the third year of a Presidential cycle. 

Looking for another reason for a rally? History suggests that the coming six months typically see seasonal gains for equity markets. 

It’s dark out there. These days, many investors are waiting for some sort of positive catalyst to emerge, whether it is a Fed signal of the end of interest-rate hikes, a cessation of war in Ukraine, or a cool-down in inflation readings.  

As was the case in the early 1990s, investors will need to climb a “wall of worry” as they wade back into markets. For example, outside our borders, economic crises are popping up with greater frequency. The recent bond market woes in the U.K. could soon be supplanted by currency problems in Japan, the world’s third-largest economy. 

The Japanese government, its major companies, and its citizens are also holders of a significant amount of U.S. debt. And changes in bondholdings held abroad could disrupt a U.S. bond market that is already showing increasing strain. 

Treasury Secretary Janet Yellen recently noted concerns “about a loss of adequate liquidity in the (bond) market,” which suggests that market-driven interest rates could move higher if bond buyers step to the sidelines. 

As one example of bond market strains, mortgage rates, which are fast approaching 7%, are no longer moving in lockstep with 10-year Treasuries. Historically, mortgage rates have been 1.5 to 2.0 percentage points above the 10-year rate, but that spread has recently widened to roughly 2.7 points. 

If Stovall and his colleagues at CFRA are correct, then investors will embrace a market rebound in the face of continuing economic and capital market strains. We’ll get a better read on how this plays out quite soon. 

This coming Friday, we’ll get a fresh look at the CPE (consumer price expenditures index), which is the Fed’s preferred inflation gauge. Then, the Federal Open Market Committee (FOMC) is expected to sharply boost interest rates in the middle of next week. And less than a week after that, voters will head to the polls, which will shed light on whether we have a split government or continued Democratic control of the executive and legislative branches. 

Despite all of the coming data points, it’s important to stay cognizant of long-term market trends, which suggest that the third term of a presidential cycle can be a banner year for stocks.  

David Sterman is a journalist and registered investment advisor. He runs Huguenot Financial Planning, a New Paltz, N.Y.-based fee-only financial planning firm. 

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