ARTICLES SEPTEMBER 2018
With less than two months before election day in the U.S., midterm elections are top of mind for politicians and voters alike. And while control of the U.S. Congress and influence over future policies may be at stake, should investors care? Do midterm elections have any effect on equity markets?
We examined over 85 years of S&P 500 data, and it turns out that stock markets do exhibit some unique characteristics during midterm election years. Of course a variety of other factors will also influence stocks in any given year, but the five charts below dig deeper into the history of midterm elections and offer some thoughts on how investors may want to think about the current cycle.
American midterm elections occur every four years, at the midpoint of the four-year presidential term, and usually result in the President’s party losing representation in Congress. Over the past 21 midterm elections, the President's party has lost an average 30 seats in the House of Representatives, and an average four seats in the Senate. There have only been two occurrences when the President’s party has gained seats in both chambers.
Net change in House seats controlled by president’s party after a midterm election
Why is this the case? For one, supporters of the party not in power are usually more motivated, leading to higher voter turnout. Also, presidents’ approval ratings typically dip in their first two years in office, which can influence swing voters and other frustrated constituents to seek change.
Since losing seats is usually the expected outcome, that scenario gets priced into markets early in the year. But the extent of a political power shift and the policy ramifications will remain uncertain for much longer, which helps explain some of the trends we will see in the charts below.
Since markets rise over long periods of time, it makes sense that a price chart of an “average” year would also steadily increase. However, isolating just the years that a midterm election were held shows that investors treat these periods differently than others. In these instances, markets tend to oscillate for most of the year, gaining little ground until shortly before the elections.
S&P 500 Index average year-to-date return (1931-present)
The old adage that markets don’t like uncertainty seems to apply here. Early in the year there is less certainty of the election’s outcome and the subsequent effects on future policy changes. But markets tend to rally when results are easier to predict in the weeks leading up to the election, and continue to rise after the polls finally close and winners are declared.
Markets during U.S. midterm election years have also exhibited unique risk profiles, as election uncertainty seem to translate directly to higher market volatility. This is especially true in the months leading up to an election, which have had significantly elevated market volatility compared to the same month in all other years.
S&P 500 Index annualized monthly volatility since 1970
Since 1970, midterm years have a median standard deviation of returns of 15.0%, notably higher than the 13.0% in all other years. Interestingly, the volatility in presidential election years was very similar to non-election years, indicating that midterm elections truly were the outlier.
The silver lining for investors is that after these bouts of volatility, markets tend to rebound strongly in subsequent months. As we saw in the earlier chart, markets typically rally shortly after midterm elections. History shows that this isn’t usually a short term blip either, as above-average returns are typical for the full year following the election cycle. Since 1950, the average 1-year return following a midterm election is 15.1%, more than double that of all other years during a similar period.
S&P Index price return one year after a U.S. midterm election
The general consensus in most media outlets is not only that Republicans will lose seats in the House this year, but it’ll be enough to give Democrats a majority position. If this comes to fruition, would markets react differently than in a year when the majority simply lost its edge but remained in control?
S&P 500 Index return in years that House majority switched parties
(Indexed to 0% on November 5th)
This scenario has only occurred three times in the past 60 years, but those three years actually showed very similar characteristics as a typical midterm election year – choppy markets early in the year and rising stocks around or after the election. While no strong conclusions can be drawn from such a small sample size, it could be of some comfort to investors that history hasn’t shown a change of control in the House as a negative market event.
Although U.S. midterm election years have exhibited these trends in aggregate over long periods of time, it is important to be mindful that every individual year is different and follows its own path. U.S. midterm elections – and politics as a whole – come with a lot of noise and uncertainty. But investors shouldn’t let that be a distraction from the fact that long-term equity returns are generated by the value of individual companies over time. The prudent investor should look past the short-term spikes in volatility that elections can bring and maintain a long-term focus.