Markets have been preoccupied with the highest rate of consumer inflation in 40 years and the Federal Reserve’s anticipated response to stem it: higher interest rates. Year to date, stock prices have slumped, volatility has surged and bond yields have risen as investors wrestle with the implications for economic growth, corporate earnings, equity valuations and bond prices. And if that is not enough to think about? This is also a midterm election year, which may have implications for how markets behave leading up to November.
Historical patterns for stock prices
The Presidential Election Cycle theory, popularized by the Stock Trader’s Almanac, asserts that stocks follow a predictable pattern of returns throughout a presidential term. While average returns in each of the four years are positive, they are typically the weakest in the first year, somewhat better in the second (the year of midterm elections) and strongest in the third before lagging in the fourth.
The pattern does not always hold true, as each presidential term has its own challenges and overlaps with different stages of business cycles. For example, the S&P 500® Index rose by 27% in 2021, the Biden administration’s first year. We can only hope it turns out to be the weakest of his current term, however unlikely. So far in 2022, the weak start for stock prices is more in line with generally subdued second-year expectations, based on history.
Market volatility and returns
Midterm election years also historically exhibit a pattern of subdued volatility to begin the year, with rising and above-average volatility as the year progresses. Volatility typically peaks in October and falls thereafter, although it remains above average through year-end, as can be seen in the chart below. It remains to be seen whether volatility will rise in the months ahead this year, as history suggests it could. January has already diverged from the historical pattern, as volatility has risen sharply.
Monthly returns also follow a pattern. Stocks tend to underperform their monthly historical averages until late in the summer, after which returns tend to rise as political uncertainty fades. There is also evidence that market drawdowns — the drop from peak price to bottom price — can be severe, with an average -17% drawdown in the S&P 500 in midterm years since 1950. The good news is that returns in the 12 months following midterm elections are typically above average, coinciding with the third year of the Presidential Election Cycle theory.
These examples are shown for illustrative purposes only and are not guaranteed. Past performance is not a guarantee of future results.
The party in power in the White House typically loses seats in midterm elections. Democrats currently hold the majority of seats in both houses of Congress: 50-50 in the Senate with the vice president in position to cast a tie-breaking vote, and 226 to 214 in the House. Given the slim margins, control of Congress could shift this fall. However, since there is already little common ground between the two parties — and, on certain issues, a lack of agreement within the Democratic party itself — the implications for policy may be limited.
In the long run, market behavior is most directly influenced by economic fundamentals. But politics can exert influence as well, especially in the short run. Knowing this can help investors prepare for what they could expect. If you have questions about market conditions or your investment portfolio, please speak with your Ameriprise financial advisor.