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  • The Dow Jones Industrial Average's best returns happen after the midterm elections.
  • The S&P 500's return is positive one year after midterm elections every time since 1960.
  •  The Federal Reserve's War on inflation could make it hard for stocks to rally, but returns have been good during other recessionary post-election periods.

Inflation is increasing expenses while GDP-busting rising interest rates are crimping revenue growth, causing corporate profits and stock prices to tumble. The mid-term Election results won’t lower inflation or sway the Federal Reserve away from its tight-money policies. Still, stocks have historically produced substantial gains after the mid-term votes are tallied.

Stocks tend to rally following mid-term elections

The stock market has produced lackluster returns during the first two years of the four-year Presidential cycle, but the final two years boast a far more promising track record.

In the five days leading up to and three days following mid-term elections, the Dow Jones Industrial Average has marched an average of 2.8% higher since 1934. The positive momentum typically carries forward into the following year, with pre-Presidential election years gaining 10.4% on average since 1833, according to the Stock Trader’s Almanac. In Presidential Election years, the average return is 6%.

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It’s not only the Dow Jones that performs well. In Real Money’s Morning Recon, Stephen Guilfoyle writes, “The S&P 500 has put together a positive return for the 12 months following a midterm election for 19 consecutive midterm elections. That's a pretty nice batting average.”

Indeed, the year after the mid-term elections has been a boon to investors. A recent study by All Star Charts shows the S&P 500 has gained an average of 15% in the twelve months following the mid-term election since 1950, with a 100% success rate for positive returns.

Stocks’ performance during the first six months following the midterm election is also encouraging. According to Schwab, the stock market has done better in the six months after the midterm elections than the six months before the elections in seventeen of the nineteen midterm years since 1946.

Shrinking the time frame by even more still produces a positive outlook, given average returns during the fourth quarter of midterm election years is 6.6%, according to Carson Investment Research.

Will this time be different?

Of course, those are simply average returns. There are years when post-midterm stock market returns have been tepid, such as 1986’s 1.9% or 2010's 2.1% return, so there’s no guarantee that the coming months will be as rewarding as they’ve been in the past.

This year could break from tradition mainly because stocks tend to do poorly when the Federal Reserve tightens, rather than loosens, monetary policy. This year, the Fed’s already increased interest rates during every meeting since March, bringing the Fed Funds rate to a range of 3.75% to 4% from essentially zero. We may only be beginning to feel the brunt of those increases because it can take nine months or longer before rate changes impact economic activity.

Given the unfriendly Fed, perhaps the best midterm comparison is 2018, when, similar to this year, the Federal Reserve was increasing interest rates and reducing the number of bonds on its balance sheet. That year, the S&P 500 fell 6.2% in the fourth quarter. It wasn’t until the Fed signaled a dovish shift that stocks took off in 2019.

Absent a change of heart by the Central Bank, it’s hard to imagine that corporate profits rebound quickly.

Following third-quarter earnings reports, the consensus year-over-year fourth-quarter earnings growth estimate for the S&P 500 has fallen nearly 9% to negative 1% since June. In March, analysts forecasted S&P 500 earnings growth of 10% in 2023. Today, analysts think growth will be below 6%.

Those headwinds prompted Guilfoyle to write, “I'm not sure how many of these past midterm elections came after a pandemic-induced economic shutdown followed by immense fiscal and monetary stimulus that were then followed by a rapid tightening of policy in order to fight inflation? Actually, I am sure. The answer is none.”

He’s not the only one to sound a cautionary tone.

In “3 Reasons Why a Year-End Rally Could Fizzle,” Real Money Pro’s Ed Ponsi says, “In a rising interest rate environment, seasonality and political gridlock are thin gruel. Supply chain issues are once again affecting companies such as Apple (AAPL), and some economists believe a recession will occur next year. It will take more than a turn of the calendar page to cure this market's ailments.”

Ponsi believes further hawkish monetary policy, ongoing COVID-lockdown disruptions in China, and tax-loss selling into year’s end to lower taxable gains could all derail historical probabilities for stock market strength.

Nevertheless, this isn’t the first time a midterm election preceded a recessionary slowdown, and returns in prior periods were undeniably good. For instance, since 1960, when a recession followed in the year after midterm elections, the average S&P 500 return was an eye-popping 24%, according to Citigroup. However, that’s based on a small sample size of just three periods: 1974, 1990, and 2006.

The Smart Play

Much media attention focuses on what stock returns may be depending on various outcomes. While arguments that one party winning versus the other resonates, the data suggests that stocks could perform well, regardless of the outcome.

For example, Comerica and Strategas crunched the numbers and discovered that average returns with Democrats in the White House and a split Congress were 13.6%. When the Republican Party holds Congress and a Democrat is President, the average return is 13%. And, if the Democrats control all three branches of government, the average return is 9.8%. All three of those returns would be welcome, given this year’s bear market returns have the S&P 500 down nearly 20%.

Given stock market returns have historically been healthy regardless of the Election’s outcome, the risk of inflation remaining stubbornly high, forcing the Federal Reserve to remain an enemy of economic growth, makes it arguably more important than Election night results.

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