Elections are here. As the midterm elections approach, investors frequently ask about the linkage between electoral politics and the movement of stock prices. As Jeff Sommer points out in one his recent New York Times columns, history carries weight even if this time “feels different.”
Source: The Market Usually Rises After the Midterms. Will This Time Be Different? The New York Times, October 28th, 2022
The Market Usually Rises After the Midterms. Will This Time Be Different?
With worries about the economy rising, the four-year presidential cycle for stocks may not follow the established pattern.
By Jeff Sommer
If you have money in stocks during this bear market, you are probably having a rough year. The bond market has been miserable, too. There have been few bright spots for investors.
Yet there is one positive portent right now: the calendar.
With a surprising degree of consistency over the past 100 years or so, stocks have followed a broad pattern that coincides with presidential terms. The months leading up to midterm elections have generally been the worst in what is known as the four-year presidential election cycle. But the stock market is about to enter a sweet spot. Stocks have usually rallied in the year after the midterms — no matter which side wins.
Market veterans take these patterns seriously but aren’t counting on them in an economy plagued by soaring inflation, rising interest rates and fears of a recession.
“We’ve studied the presidential cycle carefully, and there’s something to it,” said Philip Orlando, the chief equity market strategist for Federated Hermes, a global asset manager based in Pittsburgh. “But it’s possible that this year we will need to invoke the four most dangerous words in investors’ lexicon: ‘This time is different.’”
Gloom in the Markets
Consider, first, the overall pessimism in the markets.
In the current climate, this comment, from Mark Hackett, the chief of investment research at Nationwide, counts as fairly upbeat. “We are now entering a stage where all signs point to a recession — assuming we aren’t already in one,” Mr. Hackett said. But, he added, “the recession may already be priced into the markets, in which case the next bull run may be faster and come earlier than many investors expect,” he said.
The latest government figures show that the economy grew at a 2.6 percent annual rate in the third quarter. But the Federal Reserve says interest rates need to rise and stay high until the inflation numbers come down. The Fed’s monetary tightening is aimed at slowing the U.S. economy. Whether the consequences for working people will be mild or savage isn’t clear.
In the meantime, the coronavirus pandemic festers, the death toll from Russia’s war in Ukraine mounts, interest rates are rising elsewhere around the world, global energy costs remain elevated and U.S. relations with China are fracturing. All these concerns are weighing on the markets.
The Presidential Cycle
The party of a sitting president tends to lose seats in Congress in midterm elections, and high inflation makes matters worse for incumbents. Those are key findings of Ray Fair, a Yale economist whose long-running election model relies only on economic factors and shows the Democratic Party in an uphill climb this year.
His model, along with the polls, the prediction markets and many forecasters, suggests that Republicans are likely to win control of the House of Representatives. The Senate is up for grabs.
The issues in this election are enormous, and the vast differences between the two political parties are well chronicled.
Yet, for the stock market, history suggests that the outcome of the elections may not matter much. Shocking though this may be, since 1950, the midterm elections have brought an upturn for stocks, no matter which party has won, and no matter the issues.
The market has generally flagged in the months before the midterms and prospered after them. And it has often excelled in the year after the midterms, typically the best of the four-year presidential cycle.
Ned Davis Research, an independent investment research firm, compared stock returns for 1948 through 2021, broken down by the four years of a standard presidential term. It used the S&P 500 and a predecessor index:
12.9 percent for Year 1.
6.2 percent for Year 2, the year of the midterms.
16.7 percent for Year 3, the year after the midterms.
7.3 percent for Year 4.
The data was similar for the Dow Jones industrial average going back to 1900.
But why? There is no certain answer — and it could even be a series of coincidences — though there are plenty of explanations. The one I prefer is that presidents are politicians who try to stimulate the economy — and, indirectly, bolster stocks — for maximum effect in presidential elections.
Their first year in office is the best time to make politically painful moves, which often lead to weak markets by the time the midterms come around. After losses in the midterms, though, presidents try to give the economy a surge through expansionary fiscal and monetary policy, setting themselves (or their successors) up well for the election.
Is This an Exception?
Two powerful factors — the negative effect of a slowing economy and the beneficial influence of the midterm elections — may be in conflict, Ed Clissold, the chief U.S. strategist of Ned Davis Research, said in an interview.
On the positive side for stocks, Wall Street usually responds well to gridlock — the stasis that can grip Washington when power is divided — and such a division is the consensus expectation for the midterms. But, over the last century, when bear markets have been associated with recessions, no bear market has ever ended before a recession started, Mr. Clissold has found. The last time there was a recession in the year following the midterms occurred after the 1930 elections, during the Great Depression, a terrible era for stocks and the economy.
“A recession would be expected to be more important than the election cycle,” he said.
There are many ways of making bets on specific election outcomes, though they entail risk that I don’t favor.
For example, if Democrats defy the odds and hold onto both houses of Congress, infrastructure spending will be expected to increase. Matthew J. Bartolini, the head of exchange-traded fund research at State Street Global Advisors, said, to bet that way, you might try SPDR S&P Kensho Intelligent Structures ETF. It includes “intelligent infrastructure” companies — like Badger Meter, which supplies utilities with water-metering equipment, and Stem, which provides software and engineering for green energy storage.
If you want to bet on gridlock, you may assume that a split government will be bullish for the overall market. Then again, the need to raise the federal debt ceiling in 2023 could become a market crisis. Republicans have vowed to use the issue as leverage, forcing President Biden to cut federal spending. Similar maneuvering in 2011 led to the downgrading of U.S. Treasuries by Standard & Poor’s, sending tremors through global markets.
Tactical bets on election or economic outcomes are unreliable. That’s why what makes sense to me, regardless of the immediate future, is long-term investing in diversified stocks and bonds using low-cost index funds that track the entire market. This approach requires a steady hand, a horizon of at least a decade and enough money to safely pay the bills.
Short term, try to fortify your portfolio and build up your cash so you can handle any economic or electoral outcome.
My only specific political advice in this financial column is this: Make your voice heard. However the stock market behaves, this is an important election.