Wall Street is gripped by "midterm election anxiety," yet history tells a different story. The last two midterm cycles were marked by sharp volatility, and after each significant decline, the market discovered fresh momentum to push higher. U.S. equities have recently experienced turbulent swings, but viewed through a historical lens, the current market performance is still clearly outpacing typical midterm election years. Even if a further pullback occurs, stocks are likely to remain within the normal historical fluctuation range of the midterm cycle. As of the market selloff on August 20, the S&P 500 was still up 11.6% for the year. In comparison, based on data from 1954 to 2022, the index has averaged a 1.3% decline during the same period in midterm election years. This suggests investors' recent panic over the market dip should be assessed within a longer timeframe. Historical data shows that midterm years are rarely a straight climb; instead, the market typically endures pressure before the election, then resumes its advance once uncertainty fades.
In the lead-up to midterms, the biggest source of market stress is usually policy uncertainty. Investors tend to pre-emptively evaluate how the election results might reshape regulatory, fiscal, and economic policies, which dampens risk appetite and often triggers an equity market correction. However, this strain usually dissipates once the election outcome becomes clear. Research indicates that the post-midterm rally does not depend on which party ultimately gains control; the crucial factor is the release of pent-up uncertainty that had accumulated beforehand. The trajectory of the past two midterm years perfectly illustrates this pattern. A review by RBC Capital Markets of 2018 and 2022 found that the S&P 500 experienced substantial turbulence in the second half of both years. In 2018 and 2022, the index reached a temporary peak in August or September, subsequently declined steadily, and formed a low point in October. The market bounced back in November, only to face another pullback in December. RBC strategist Lori Calvasina noted that despite the significant swings in those two years, the corrections ultimately helped build a more solid foundation, setting the stage for gains in the following year.
That said, the midterm cycle is not the sole driver of market direction. RBC points out that market pressure in 2018 was also exacerbated by trade tensions, while 2022 was influenced by sliding tech sector earnings and the Russia-Ukraine conflict. Meanwhile, Federal Reserve policy and interest rate changes have consistently remained critical variables for equities. What makes this year unique is that U.S. stocks have not weakened ahead of the election as per the traditional script; instead, they have rallied substantially in the pre-election period. This has led some investors to worry that the current advance may have prematurely consumed the gains typically reserved for the post-midterm phase. However, historical data does not support such concerns. Statistics reveal that a strong performance before midterms does not lead to a weaker market in the year following the election. On the contrary, the stronger the market is before the election, the larger the subsequent rally has historically been. The year 1998 serves as a relevant case. By mid-August of that year, the S&P 500's gain was similar to this year's pace, and in the 12 months following the midterm election, the index surged 22%.
Longer-term data also underscores the stability of post-midterm market performance. Since the S&P 500's inception in 1954, the index has posted a gain in the 12 months following every single midterm election. In contrast, during the other three years of the presidential term cycle, the index has experienced declines 28% of the time over comparable periods. Even so, new pressure points loom for the market. RBC believes the overall environment for U.S. stocks over the next 12 months remains positive, but the trajectory of interest rates represents the biggest source of risk. If recession fears do not escalate significantly, or if the market is not hit by a sudden spike in rates, the magnitude of any equity correction is likely to remain contained within the 5% to 10% range. From a valuation perspective, RBC notes that the forward price-to-earnings ratios for the S&P 500 and the Nasdaq 100 are currently in the middle of their post-pandemic historical ranges, and large-cap valuations sit at similar levels, indicating the market is not in extreme overvaluation territory.
Consequently, recent volatility does not suggest that the post-midterm rally pattern has broken down. Historical experience indicates that the fluctuations around election time are often a process of the market digesting uncertainty, but investors also need to avoid underestimating risks just because of a long-running bull market. The market could continue to climb, yet excessive optimism carries its own set of new dangers.
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