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Capital Market Impact

Stock investors gauge risk ahead of midterms.

September 08, 2022

We’re entering a historically perilous time in the stock market, with September and October generally being poor months for equity returns. Moreover, the U.S. midterm elections are on the horizon, meaning the coming weeks could be uncertain and emotionally charged.

But if there’s a silver lining for investors in the current market environment, it’s in anticipating what the stock market may have in store following the upcoming midterms. Over the past 30 years, market returns have been strong in the months after midterm elections, with one-year returns from Election Day usually reaching double digits. As this week’s chart shows, during previous midterm election years going back to 1994, the S&P 500® Index struggled for momentum in the ten months before Election Day. But once the midterms are decided, stock performance has demonstrated a definitive uptrend.

Average performance for the S&P 500 Index before & after mid term elections (1994-2018)

The reason may also have something to do with the bigger election cycle. According to Strategas, much of the post-midterm stock performance results from market expectations for increased fiscal or monetary stimulus before the next presidential election. But the current economic and political environment may not accommodate additional fiscal stimulus, with inflation continuing to run rampant and government spending remaining at high levels.

Wall Street is wondering if equity markets will retest their June lows after weighing Federal Reserve Chair Jerome Powell’s unwavering commitment to fighting inflation. Global stock markets sold off following Powell’s speech as investors coalesced around the notion that the Fed would not support the market as quickly as investors had been accustomed to over the past decade.

Before the recent market selloff, the S&P 500 tested its 200-day moving average. At the high, the market traded at 18-times forward earnings, rebounding from the June lows of approximately 15-times forward earnings. The S&P 500 valuation has settled at around 17-times forward earnings as of this writing. As investors try to gauge fundamentals and future earnings in the coming quarters (likely to be revised lower due to margin pressure), the market’s risk/reward outlook looks a little hazy. However, the outlook is not solely skewed to the downside.

First, investor sentiment and positioning remain incredibly negative. From a contrarian point of view, this can be seen as a positive since it would imply, in theory, that investors anticipate bad news and should not have to sell because they can hedge their exposures. Second, the market’s rally since mid-June was encouraging from a breadth standpoint. At the market’s recent high, around 90% of the stocks within the S&P 500 traded above their 50-day moving averages. This movement was very encouraging for the bulls as historical retracements over 50% generally bring on new bull market rallies.

However, the current market environment is unique. Unlike prior retracements, the Federal Reserve is hiking rates, and the yield spread between 2-year and 10-year Treasuries is negative. These are critical distinctions that investors must consider before declaring “all clear.” Additionally, investors should remember that elections have little impact on long-term investment returns. This underscores a crucial takeaway for investors this November: Don’t let emotional investing be a part of your investing playbook.



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