Stocks have gone nowhere this year, despite generally good news on corporate profits and economic fundamentals. And now the midterm elections, less than 7 months away, may be starting to weigh on share prices.
Stocks tend to struggle during midterm years, regardless of which political party is in charge. Since 1946, the S&P 500 stock index has fallen 50% of the time during the six months leading up to a midterm election, according to Sam Stovall, chief investment strategist for CFRA. Stocks do worse during the midterms of a president’s first term—the type of year we’re in now—falling 60% of the time, with an average decline of 3%.
Midterms are significant because there’s often a snapback effect in which the party that took or strengthened control of government two years prior typically suffers losses in the midterms. The president’s party, for instance, loses an average of 29 seats in the House of Representatives during first-term midterms, according to research firm Strategas. Since Republicans have only a 23-seat margin, a typical performance this year would flip the House to Democrats. Some analysts predict a much bigger “blue wave.”
Investors care because any change of control in Congress will change the policy outlook. Democrats would have a newfound ability to block Republican legislation, which would mean one of two things: Either gridlock, as nobody compromises and nothing gets done, or cooperation on issues that have some support in both parties, such as infrastructure spending. President Trump might even find a bit more support for tougher trade protectionism, which some Democrats favor.
Whatever the outcome, the lead-up to contested midterms—as we seem sure to have in November—is heightened uncertainty and volatility, which, of course, weighs on stocks. Among other things, investors will ponder the implications of divided government on tax and regulatory policy, and Federal Reserve decision-making. “High uncertainty and the long road to Election Day make it difficult for investors to trade today based on potential policy developments in the next Congress,” Goldman Sachs said in a recent note to clients.
Stocks do tend to rally as a midterm draws near, and finally passes. In the fourth-quarter of a midterm election year, the S&P’s average return is a robust 7.5%. And October of a midterm election year is typically the best-performing month for stocks in the entire four-year cycle, according to Strategas. That suggests investors take defensive positions in the months leading up to a midterm, but by October, with stocks down, they try to buy the dip in anticipation of a post-election relief rally.
The difference this year, however, could be a return to divided government and a do-nothing Congress once the elections are over. “Gridlock tends to be good for bonds,” Stovall says, “yet not for stocks, due to the lack of leadership.” And both parties would get blamed for that.