Stock-market gains are weakest after Midterm results like these

While US midterm election results historically bode well for stocks regardless of which party wins, some Wall Street strategists are warning clients to temper their bullishness this time around.

From a fundamental perspective, there is the threat of a corporate earnings slowdown due to tougher federal and state oversight of the artificial intelligence industry by newly empowered Democrats. Elevated interest rates also raise questions about whether history will repeat itself.

And on closer inspection, even the historical analogs showing stocks always rise in the year after midterms are not overwhelmingly bullish. Periods with a Republican in the White House and Democrats in control of both houses of Congress are among the weakest setups for equity returns, with the S&P 500 averaging an annual gain of just 4.9% since the early 1950s, according to data compiled by Carson Investment Research. A split Congress and a Republican president have typically been more favorable, with the index rising 14% annually.

“The track record is not as good,” Lori Calvasina, RBC Capital Markets head of US equity strategy, said on Bloomberg Television of this type of divided government.

For the time being, the removal of uncertainty surrounding the next Congress appears to be inspiring investors to buy the pre-election dip that pulled the S&P 500 down 3.2% from its last record on Oct. 6 and sent the tech-dominated Nasdaq 100 lower by almost 10% over the same period.

Futures tied to the S&P 500 dropped as much as 1.4% as the results trickled in late Tuesday and Nasdaq 100 contracts tumbled as much as 2.4% before both reversed direction to trade higher Wednesday morning. Options pricing indicates that the S&P 500 is poised to swing nearly 1% in either direction on Wednesday — among biggest implied moves for the index over the next month, according to Citigroup Inc. data.

The benchmark index is more likely to advance than decline following the midterms since President Donald Trump holds veto powers, according to a scenario analysis by JPMorgan’s Market Intelligence desk led by Andrew Tyler.

“Many fear an AI selloff on assumed higher regulation, but it will be difficult to implement any policies as Trump has stated that he will not sign any bills that limit AI expansion and Dems cannot achieve a veto-proof majority in both chambers of Congress,” Tyler wrote in a note to clients.

Meanwhile, history backs up the case for a post-election lift for US equities: The S&P 500 has typically performed far better after midterm elections than before them. That pattern has generally held when the opposition party wins control of one or both chambers of Congress.

One year following every US midterm election since 1950, the S&P 500 finished higher with an average gain of 15%, according to data compiled by Jeffrey Hirsch, editor of the Stock Trader’s Almanac, who correctly forecast the rally after the 2008 financial crisis. One month after the vote, the equities benchmark rose nearly 79% of the time, averaging a gain of 1.6%.

One potential explanation is the removal of election uncertainty that can weigh on risk appetite ahead of the vote.

“Economic data, interest rates, corporate earnings and global events can all move markets,” Hirsch said. “But with the election outcome known, investors may have a clearer political landscape to assess.”

Of course, that doesn’t mean the path was always smooth, and history shows a range of different short-term outcomes.

Take the midterms in 2018, which resulted in a divided government after Democrats won control of the House and Republicans kept the Senate. The S&P 500 initially soared by 2.1% a day after the election, yet the index was 2.2% lower a month later and posted a 6.2% loss for 2018 after the Federal Reserve raised interest rates four times.

Midterm years are historically the most volatile and tend to see the largest peak-to-trough drawdown of nearly 18% on average out of the four-year presidential cycle, Carson data show. Earlier this year, the S&P 500 sank as much as 9.1% in late March. Since then, the index has added $11 trillion in market value on a strong economy and robust earnings.

The max drawdown tends to occur later in the year. That means there may be more room for equities to fall from here, according to Sam Stovall, chief investment strategist at CFRA and veteran expert on stock market history for the past four decades.

“There will be a time when this bull market ends, but I don’t think valuations are stretched — unless we end up seeing downward revisions to earnings forecasts,” Stovall said. Though he has a year-end target of 8,050 for the S&P 500, about 6.4% above Tuesday’s close.

“What’s truly driving the stock market,” Stovall added, “is earnings and interest rates.”