Why midterm election years are tough for the stock market

These months are historically the weakest for the market in a presidential term. Aside from coincidence, there are several possible explanations.

  • By Jeff Sommer,
  • The New York Times News Service
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The stock market’s decline and the tightening of financial conditions that have accompanied it since the start of the year are unique to 2022.

The effects of the coronavirus pandemic, roaring inflation and Russia’s invasion of Ukraine are emphatically different from anything that had come before.

Yet for stock market mavens who have read up on the four-year presidential election cycle, what is occurring in the markets looks quite familiar. This is a midterm election year, after all, and numbers going back more than a century show that the second year has generally been the weakest for the stock market in a president’s term.

“Investors may take solace in the fact that the market has been here many times before,” Ed Clissold and Thanh Nguyen, two analysts for Ned Davis Research, an independent financial research firm, wrote in a recent report on the presidential cycle.

The numbers

The market soared early in Donald J. Trump’s presidency, but it hit a wall in 2018 — the midterm year — and at one point gave up 18.8 percent of its gains, according to Ned Davis Research’s tabulation of Dow Jones industrial average (.DJI) data.

Similarly, the Dow rose smartly early in President Biden’s term, only to decline more than 12 percent at its trough so far this year, again according to Dow data.

This rough pattern isn’t a constant throughout history, but it has occurred quite frequently in presidencies going back to 1900. After a weak stretch in the midterm year, the stock market has usually rallied.

Consider the numbers. These are the median annualized returns from 1900 through 2021, freshly tabulated by Ned Davis Research for the different years of a presidential term, using the Dow:

  • 12.7 percent for Year 1.
  • 3.1 percent for Year 2, the midterm year.
  • 14.8 percent for Year 3, the pre-election year.
  • 7.4 percent for Year 4, the election year.

Ned Davis Research ran the numbers a second time, for 1948 through 2021, using the S&P 500 (.SPX) and a predecessor index. The S&P 500 is a broader proxy for the overall U.S. stock market than the Dow, but it has a shorter history. While the details were different, the pattern remained the same:

  • 12.9 percent for Year 1.
  • 6.2 percent for Year 2.
  • 16.7 percent for Year 3.
  • 7.3 percent for Year 4.

But why?

Why the midterm year — and, in particular, the first half of the year — is often a weak period for stocks is unclear. It could be a series of coincidences; establishing cause rather than correlation, especially over such a long period, is impossible.

Yet many researchers in the academic world and on Wall Street have examined the numbers and concluded that the pattern of midterm year weakness, and greater strength for stocks later in the presidential cycle, is fascinating enough to merit further study. “The pattern is hard to ignore,” Roger D. Huang wrote in a 1985 paper in the Financial Analysts Journal.

He noted another puzzling fact. Although Republicans tend to be portrayed as the party of business, the stock market generally prefers Democrats — an affinity sustained for a long time. From 1901 through February, for example, and adjusted for inflation, the Dow returned 3.8 percent annualized under Democratic presidents, versus 1.4 percent under Republicans, Ned Davis Research found.

Furthermore, based on the historical data, the best political alignment for the stock market is one that could arise this November if the Democratic Party has a major setback. Since 1901, a Democratic president combined with Republican control of both houses of Congress has produced annualized real stock returns of 8 percent, using the Dow.

Aside from sheer coincidence, there are several possible explanations for the presidential cycle and, specifically, for the typical midterm swoon and recovery in the last half of a presidential term.

Presidents as politicians

In an interview, Mr. Clissold, the chief U.S. strategist for Ned Davis Research, noted that the stock market abhors uncertainty. It is well understood that most often, the president’s party loses ground in midterm congressional elections. But that limited insight early in a president’s second year only makes it harder to make bets on the direction of policymaking in Washington.

“That could all be weighing on the market in a cyclical pattern,” he said.

There is another common theory, one that I find appealing because it does not flatter the political establishment. Yale Hirsch, who began describing the presidential cycle in the annual Stock Trader’s Almanac in 1968, explained it to me more than a decade ago.

The theory starts with the premise that even the best presidents are, first and foremost, politicians. As such, they use all available levers to ensure that they — or their designated successors — are elected.

These efforts often contribute to strong stock market returns leading up to presidential elections, when it is in presidents’ greatest interest to stimulate the economy.

In the first half of a presidential term, however, when the White House and Congress get down to the mundane business of governing, there is frequently a compelling need to pare down government spending or to encourage (substitute “pressure,” if you prefer) the nominally independent Federal Reserve to raise interest rates and restrict economic growth. The best time to inflict pain is when a presidential election is still a few years away, or so the theory goes.

As Mr. Hirsch told me back then, it’s good politics “to get rid of the dirty stuff in the economy as quickly as possible,” an exercise in fiscal and monetary restraint that tends to depress stock market returns in the second year of a presidential cycle.

That would be where we are now.

Where Biden stands

Through March, despite the bad stretch in the market this year, stock returns have been comparatively good during the Biden presidency, with a cumulative gain in the Dow of 12.1 percent, well above the median of 8.1 percent since 1901. In the equivalent period, the Dow under Mr. Trump gained 22.2 percent.

Both performances were vastly behind those of the leaders, according to Ned Davis Research. The top three, from inauguration through March 31 of their second year in office, were:

  • Franklin D. Roosevelt in his first term, 89.2 percent.
  • Ronald Reagan in his second term, 48.2 percent.
  • Barack Obama in his first term, 31.1 percent.

What are we to make of all this?

Well, the pattern of the presidential cycle suggests that the market will begin to rebound late this year and rally next year — the best one, historically. That result is unlikely, though, if the Federal Reserve’s fight against inflation plunges the economy into a recession, as some forecasters, including those at Deutsche Bank, are predicting.

I wouldn’t count on any of these predictions or patterns. As an investor, I’m doing my usual thing, buying low-cost index funds that mirror the broad market and hanging on for the long term.

But I’ll keep looking for patterns anyway. The pageantry of American politics and stock market returns is a compelling spectacle, even when none of the expected outcomes come true.

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