With a rough Q1, Q2, and Q3 in the books for the S&P 500 and Q4 now underway with midterm elections just days away, US stocks are entering a historically bullish three-quarter stretch. One political driver helping stocks move forward is the US Midterm election. Average returns since 1925 show that in US midterm election years, returns are relatively subdued in the first three quarters of the year, and then starting in Q4 and through Q1 and Q2 of the following year, equity returns tend to do very well. In fact, the three-quarter period (Q4, Q1, and Q2) after a midterm election is the most substantial performance phase throughout the four-year US presidential cycle. Since 1926, S&P 500 returns during Q4 of the midterm year in a US presidential cycle—and the subsequent two quarters—have been positive more than 87% of the time, far above stocks’ non-midterm quarterly positive frequency of 64%.
Let’s look at why this happens. When a new US president enters office, it’s frequently the case that there is a unified government—one party in control of the presidency, the House of Representatives, and the Senate. In a unified environment, it’s easier for the government to pass legislation, which means there is generally more legislative activity which could create disorder. And markets tend not to do as well in an environment where winners and losers can get created by legislative change.
However, as the presidential cycle gets closer to the midterm election, the president’s party often loses seats in the House of Representatives and the Senate. On average, the president’s party loses seats in the House of Representatives 89% of the time, and in the Senate, the president’s party loses seats 71% of the time. So, given the narrow historical margins that the Democrats hold in the House and Senate, the US will probably witness tighter gridlock after the midterm election this year.
Interestingly, current betting market odds as of 10/11/2022 show the Republicans have a higher than 75% chance of winning at least one chamber of Congress. That means as we go into 2023, we will probably have an environment of political gridlock with much less legislative change creating a more predictable and stable legislative environment, which stocks favour.
In 2023, it is very plausible to watch fears regarding tight monetary policy and high inflation fade, creating an environment where stocks do very well as uncertainty declines. That said, we could see new lows to the current bear market over the short term because bear markets commonly hit their bottom near midterm elections. Of the past ten bear markets in the S&P 500, we saw seven bottom within six months of the midterm election (1962, 1966, 1970, 1974, 1982, 1990, and 2002). Interestingly, the concentrated periods around the 1960s and 1970s, with higher inflation and higher interest rate periods are similar to right now—add coincidental optimism.
So let’s recap, equity markets are about to enter the three consecutive quarters that begin with the midterm election—the strongest positive return phase in the US presidential election cycle. We also know the president’s party tends to lose seats in midterm elections, often resulting in a gridlocked government that produces fewer legislative changes. Fewer changes create a more stable and orderly environment for business.
For this reason, the upcoming midterm election in the US could be a breath of fresh air for equities. No one can be confident about where stocks head immediately, but it matters little with all the fears today so widely discussed and leading many to conclude stocks shouldn’t go up. So, remember it is common for pre-midterm market weakness and even bear markets to witness powerful post-midterm market strength, which should excite everyone.