Markets may gain momentum after the midterms, history suggests

The fall of 1991 was a stressful time for investors. The country had just entered a war in Iraq, interest rates were rising and the US economy was approaching recession. In other words, it was a terrible setup for stocks — and similar to the current backdrop. But during the fourth quarter of 1991, the S&P 500 began a rally that would lead to a 33% gain over 12 months, according to Sam Stovall, chief investment strategist at CFRA Research.

Voters cast their vote on Election Day. PAUL J. RICHARDS/AFP/Getty Images

Stovall has followed market trends for more than four decades and spent much of that time as chief market strategist at Standard & Poors. In late October, Stovall and several colleagues from CFRA hosted a market outlook webinar that focused on the future for stock markets, using the lens of the upcoming midterm elections to determine potential returns.

No more freshmen, not even a junior. So far, market returns in 2022 are exactly in line with historical trends. In the second year of a presidential cycle, stock markets typically lose ground in the second and third quarters, Stovall notes. The 20.9% decline in the S&P 500 over the past two quarters is certainly in line with the trend of a second slump.

Still, the fourth quarter of the second year has historically marked a turning point. Stock markets have been up 84% of the time, with an average gain of 6.4% for the S&P 500. Over a 12-month period (until the end of the third quarter of year three), the average gain is 21, 9%. (The large-cap index is up about 5% so far in the fourth quarter of 2022.)

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

Indeed, Stovall says the timing of a market reversal is near. For five interim 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 is certainly an incentive for investors.”

Where are market profits most sharply focused? CFRA research found that information technology stocks were the strongest gains, rising on every occasion in year three of a presidential cycle, averaging 29.9%. There is potential symmetry here. Technology stocks are down 29% in the past 12 months. In the third year of the cycle, health stocks and consumer discretionary posted an average gain of nearly 20%.

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Stovall thinks investors will breathe out once voters have gone to the polls. “The markets will rise when the uncertainty surrounding the elections is over,” he says. And he adds another important caveat: “Don’t try to wait for a specific ‘turning problem’ before you go bullish.” Investors will certainly be pleased to see signs of calm in the stock and bond markets. In a recent note to clients, Stovall wrote that “yields prior to the midterm elections were traditionally volatile,” but adds that volatility has fallen by an average of 28% in the third year of a presidential cycle.

Looking for another reason for a rally? History indicates that stock markets tend to show seasonal gains over the next six months.

It’s dark there. Today, many investors are waiting for some sort of positive catalyst, be it a signal from the Fed that the rate hikes are over, an end to the war in Ukraine, or a cooling of inflation numbers.

As was the case in the early 1990s, investors will have to climb a “wall of worry” as they wade back into the markets. For example, economic crises are increasingly occurring outside our borders. Recent problems in the UK bond market may soon be supplanted by currency problems in Japan, the world’s third largest economy.

The Japanese government, its major corporations and its citizens also have a significant amount of US debt. And changes in bond holdings abroad could disrupt a US bond market that is already showing increasing tension.

Treasury Secretary Janet Yellen recently reported concerns “about a loss of sufficient liquidity in the (bond) market”, suggesting that market-driven interest rates could rise if bond buyers sit on the sidelines.

An example of bond market tensions: Mortgage rates, fast approaching 7%, are no longer in step with 10-year government bonds. Historically, mortgage rates have been 1.5 to 2.0 percentage points above the 10-year rate, but that spread has recently widened to around 2.7 points.

If Stovall and his colleagues at CFRA are right, investors will embrace a market recovery in the face of ongoing economic and capital market tensions. We’ll read more about how this ends soon.

Coming Friday, we’ll take a fresh look at the CPE (Consumer Price Expenditure Index), the Fed’s favorite inflation gauge. Subsequently, the Federal Open Market Committee (FOMC) is expected to raise interest rates sharply 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 over the executive and legislature.

Despite all the data points to come, it’s important to stay on top of long-term market trends that suggest the third term of a presidential cycle could be an excellent year for stocks.

David Sterman is a journalist and registered investment advisor. He runs Huguenot Financial Planning, a New Paltz, NY-based financial planning company that operates on a pay-only basis.

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