Can Midterm Elections Move Markets?

In a year when soaring inflation, the war in Ukraine, and a bear market have commanded headlines, the U.S. midterm elections risked becoming an afterthought. But now the election is coming back into focus and with good reason. But while control of Congress may be at stake, do midterm elections have any effect on equity markets? After examining more than 90 years of data, the resounding answer is yes, markets have behaved differently during midterm election years, and this year is no different. Below are five things you need to know about investing, especially during this political cycle.

The president's party typically loses seats in Congress

Since losing seats is so common, it's usually priced into the markets early in the year. But the extent of a political power shift — and the resulting policy impacts — remain unclear until later in the year, which can explain other trends.

Midterm elections occur at the midpoint of a presidential term and usually result in the president's party losing ground in Congress. Over the past 22 midterm elections, the president's party has lost an average of 28 seats in the House of Representatives and four in the Senate. Only twice has the president's party gained seats in both chambers.

Why is this usually the case? First, supporters of the party not in power usually are more motivated to boost voter turnout. Also, the president's approval rating typically dips during the first two years in office, which can influence swing voters and frustrated constituents.

Market returns tend to be muted until later in midterm years

Despite the uncertainty, investors shouldn't sit on the sidelines or try to time the market. The path of stocks varies greatly each election cycle, and the overall long-term trend of markets has been positive.

As you can see in the chart above, an analysis of returns for the S&P 500 Index since 1931 revealed that the path of stocks throughout midterm election years differs noticeably compared to all other years.

Since markets typically rise over long periods of time, the average stock movement during an average year should steadily increase. But we found that in the first several months of years with a midterm election, stocks have tended to have lower average returns and often gained little ground until shortly before the election.

Markets don't like uncertainty — and that adage seems to apply here. Earlier in the year, there is less certainty about the election's outcome and impact. But markets have tended to rally in the weeks before an election and have continued to rise after the polls close. So far, 2022 has been another example of a midterm election year with lackluster returns, although the impact of politics has been minimal compared to that of inflation and rising rates.

Midterm election years have had higher volatility

It may come as no surprise then that market volatility is higher in midterm election years, especially in the weeks leading up to Election Day. Since 1970, midterm years have a median standard deviation of returns of nearly 16%, compared with 13% in all other years.

Elections can be tough on the nerves. Candidates often draw attention to the country's problems, and campaigns regularly amplify negative messages. Policy proposals may be unclear and often target specific industries or companies.

Market returns after midterm elections have been strong

The silver lining for investors is that markets have tended to rebound strongly in subsequent months, and the rally that has often started shortly before Election Day hasn't been just a short-term blip. Above-average returns have been typical for the full year following the election cycle. Since 1950, the average one-year return following a midterm election was 15%. That's more than twice the return of all other years during a similar period.

Of course, every cycle is different, and elections are just one of many factors influencing market returns. For example, investors will need to weigh the impacts of a potential U.S. recession and global economic and geopolitical concerns over the next year.

Stocks have done well regardless of the makeup of Washington

There's nothing wrong with wanting your preferred candidate to win, but investors can run into trouble if they place too much importance on election results. That's because, historically, elections have had little impact on long-term investment returns.

In 2020, many investors feared the "blue wave" scenario or Democratic sweep. But despite these concerns, the S&P 500 rose 42% in the 14 months following the 2020 election (from November 4, 2020, through January 3, 2022).

Going back to 1933, markets have averaged double-digit returns in all years that a single party controlled the White House and both chambers of Congress. This is just below the average gains in years with a split Congress, a scenario that many believe is a strong possibility this year. Even the "least favorable" outcome — when the president's opposing party controls Congress — notched a solid 7.4% average price return.

What's the bottom line for investors?

Midterm elections — and politics as a whole — generate a lot of noise and uncertainty.

Even if elections spur higher volatility, there is no need to fear them. The reality is that long-term equity returns come from the value of individual companies over time. Smart investors would be wise to look past the short-term highs and lows and maintain a long-term focus.

As always, we cannot emphasize enough that Aevitas clients' portfolios are constructed for their particular needs, time horizon, and risk tolerance; appropriately diversified portfolios will help weather volatility. Patience does not equal inaction, and we continue to monitor the markets and economic data and make appropriate changes to portfolios as needed. History shows us that patient investors will be rewarded with wealth protection and creation.