midterm elections and stocks

Good News, Bulls: The Midterm Elections Are Coming Soon

Whoa, what an ugly month it’s been! The S&P 500, Nasdaq and Dow Jones Industrial Average have fallen 8%, 6% and 11%, respectively. The Russell 2000 has been leading the decline, tanking 13% this October. It’s left investors flustered and defeated, but with the midterm elections just around the corner, maybe there’s reason for optimism.

Oddly enough, does anyone know why the stock market is declining? A knee-jerk answer might be to suggest its the trade war between the U.S. and China. But that’s been an ongoing saga, with little worry being reflected in the market until this month. Others might say earnings, but the decline began before quarterly results were released. Further, many of these results have been quite strong as well.

Weren’t interest rates a pretty big catalyst? They were, particularly as investors collectively regurgitated fears of the 10-year reaching a 3.5% yield. But that can’t explain all this weakness, as the 10-year topped out near 3.25% on October 5th. While that hammered the S&P 500 in the days and weeks after, consider that the index made a new low on October 29th while 10-year rates have trended lower for three weeks. 

The reason doesn’t matter; it is what it is. Those that have survived this month’s plunge don’t really need an explanation on what happened, they care much more about what’s going to happen. So what should we expect going into November?

Trading Around Midterm Elections

Historically speaking, the midterm elections are a great catalyst for stock prices. So if you’re a bull, perhaps you’re in luck. Dating back to 1946 and during the years that have midterm elections, the S&P 500 has a tendency to end the year higher than its October lows.

How accurate are we talking? Try 18 years out of 18 years during that span with an average return of more than 10%. That’s pretty convincing data. 

Some may argue that its performance is tied to the lows of October — who can time the bottom? But realize that the stock market didn’t bottom in early or mid-October. In fact, we don’t even know that the bottom is in. As we just noted, the S&P 500 made a new low on October 29th. With just one more day to go though, investors will have a reasonable risk/reward setup going into the last two months of the year and ahead of the Santa Claus rally — provided they’re into seasonal statistics.

The numbers go a step further, too.

So many people talk about what a stellar year the stock market tends to have during midterm elections. However, many do not realize a bulk of those gains come in the fourth quarter. The chart below is from LPL Research, and highlights the average performance of the S&P 500 during midterm election years since 1950. The action is pretty compelling for a seasonal investor.

how stocks perform during midterm elections

Data from LPL Research

(Note the dip in early November, when voting takes place).

Risk to the Midterm Elections Trade?

We outlined several of the major — and supposed — catalysts to the recent decline. Those include higher interest rates from the Federal Reserve and an escalating trade war with China. However, should those situations deteriorate from current conditions, it’s possible we’ll see that reflected in the stock market.

For instance, investors expect the Fed to again raise interest rates in December. While this action has long been telegraphed by the Fed, stock investors still don’t like higher rates. Nor does the president. So should the Fed hike once again near year’s end, that could keep a lid on stock prices. A further escalation of the trade situation won’t help matters, especially if it impacts large cap tech, transports, industrials, Apple (AAPL), Boeing (BA) and others.

Given the poor performance of the Chinese stock market and the heightening tensions with the U.S., it wouldn’t be surprising to see the trade situation get worse before it gets better. Taking it a step further, with the midterm elections in the first full week of November, one could imagine the Chinese government turning up the heat ahead of the vote.

Finally, the election outcome could be a risk too. Is the market baking in a Democratic “blue wave” to sweep Congress, essentially tying up President Trump and his future initiatives? Or will we have another term with Republicans controlling the House and the Senate? We’re obviously not picking sides in the matter here, but simply stating the obvious from an investment perspective. That being, the results of the midterm elections could have an impact on the stock market, particularly if investors believe the outcome will hinder the economy, the nation’s growth or both. 

The question becomes, how much of those outcomes are being priced into the market right now?