The outcome of this year’s election will have ramifications on the next Congressional agenda, including fiscal policy, spending priorities, and potential changes in tax policy.
So, the question on many investors’ minds is: Should I alter my investment portfolio after Election Day?
The short answer is no, in our view.
The markets are influenced more by expected financial conditions and economic catalysts than by midterm elections. We think investors should focus on the overall market valuation and economic outlook and not the midterms.
What We Can—and Can’t—Learn From Previous Midterm Elections
Historically, some analysis has shown that equity markets have tended to underperform in the runup to midterms and then outperform thereafter. This course of events would suggest that investors should underweight equity exposure prior to the election and then move to an overweight afterward. Yet, I suspect that this historical precedent is of little practical value today.
These historical analyses can be skewed based on the time periods chosen to measure before and after the elections. For example, the results will change if you use a three-, six-, or 12-month time frame.
In addition, the results will differ greatly depending on how far back in time one measures—different analyses have started during the Great Depression, after World War II, and after 1962. In my opinion, the technical aspects and dynamics of the market today are so different from earlier periods that I would hesitate to use any data prior to 1990.
Furthermore, as mentioned, we believe the markets are influenced more by expected financial conditions and economic catalysts than by midterm elections.
It’s no surprise to us that the stock market has dropped thus far this year. In our 2022 Market Outlook, we noted that, coming into the year, the equity market was overvalued and would have to contend with four main headwinds:
1) Slowing rate of economic growth
2) Tightening monetary policy
3) High inflation
4) Rising interest rates
For the foreseeable future, we expect that these four headwinds will continue to exert greater impact on the markets than the midterms, and that volatility will remain elevated until these headwinds begin to abate.
Historic Examples of Stock Market Activity Leading Up to Midterms
Over the past 30 years, there have been numerous instances in which market volatility leading up to midterms has coincided with either deteriorating fundamentals or external catalysts.
Consider the factors surrounding the other midterm elections of the past 30 years:
- In 2018, stocks rose throughout the year and peaked in September. However, the Federal Reserve had already been tightening monetary policy for a year and that tightening began to pressure economic growth in the third quarter. In addition, global economic growth, especially in China, appeared to be rapidly slowing. Markets fell throughout autumn, through midterms, and didn’t bottom out until the end of 2018. In November, the Fed halted additional monetary tightening and the markets began to recover in early 2019.
- In the fall of 2014, energy stocks plunged along with oil prices as new supply from fracking shale came online. Economic growth slowed in the second half of the year, and fourth-quarter gross domestic product dropped to only 1.8%. A risk off sentiment permeated the markets in October as cases of Ebola virus spread into the United States. A flash crash in the U.S. Treasury market further damaged market sentiment.
- In 2010, the markets were still working through the impacts of the global financial crisis. In the second half of the year, the economic rebound appeared to wane, and unemployment remained near double digits. In order to combat this softness, the Fed launched a second round of quantitative easing in November 2010, consisting of a $600 billion bond-buying program.
- Other examples include: In 2002—the market was still in the process of trying to find a bottom after the burst of the dot-com bubble. In 1998—a hedge fund, Long Term Credit Management, blew up in a spectacular fashion and the liquidating of its positions wreaked havoc on market technicals. In 1990—the economy was just recovering from the recession at the beginning of the year, and Iraq had just invaded Kuwait shortly before the midterms.
Altogether, the additional confounding factors suggest that solely attributing the volatility to the runup to the midterms should be taken with a grain of salt.
Your Election Bets May Not Pay Off
Trying to buy and sell stocks based on the party that will hold a controlling or blocking position in government is fraught with risks. Even if you correctly predict the outcome, the investment implications are far from certain.
Although one party may control both the executive and legislative branches, numerous factors may limit the scope of what that party will be able to accomplish. Both domestic and economic factors, as well as external geopolitical factors, may arise to derail the attention of the controlling party.
It can also be especially precarious to project the exact timing of when that party will be able to enact new legislation and then how quickly that related spending will occur. For example, following the 2020 elections, it took 1.5 years for the Democrats to pass legislation that boosted spending on renewable energy.
Once it was clear that this legislation would pass, the stocks of companies focused on renewable energy immediately rose. Yet, even accounting for this surge, only a few of these stocks have outperformed the broad market since November 2020, and several have significantly underperformed over this time period. The combination of the underlying long-term fundamentals and valuation are much more important to long-term investment success than trying to pick winners/losers based on potential government intervention.
What Should Investors Expect in the Foreseeable Future?
The markets are looking for clarity as to when the economy will regain its footing and begin a meaningful and maintained rebound as well as evidence that inflation will begin to subside and trend downward. Until those factors are evident, we expect that the markets will remain especially volatile and can surge or plunge as economic and inflationary metrics are released.
Looking forward, we expect:
- Gross domestic product will remain sluggish and won’t start to grow again until the second half of 2023.
- The Fed will conclude tightening policy by the end of 2022.
- Momentum may push interest rates slightly higher over the near term, but the preponderance of rising long-term rates has already occurred.
- Inflation will begin to moderate over the next few months and subside in 2023.
- Earnings growth for U.S. stocks will remain sluggish. Companies with significant international exposure will be under added pressure from the appreciation of the U.S. dollar.
- Liquidity will be drained from markets as the Fed’s quantitative-tightening program allows $95 billion worth of U.S. Treasuries and mortgage-backed securities to roll off its balance sheet.
We think the combination of these factors will provide the Fed the room it needs to begin easing monetary policy in mid-2023.
What’s an Investor to Do?
- Stick with a long-term plan based on your investment goals and risk tolerances. In our view, this plan should incorporate a range of allocations in order to take advantage of changes in market valuations and periodically rebalance their investment allocations.
- Consider adding to your equity exposure. When market valuations drop lower, you have an opportunity to judiciously add to equity market exposure. When the market recovers, you can lock in gains and reduce equity exposure back to your long-term allocation target. And when the markets trade above fair value, it’s time to underweight equity exposure. According to a composite of the approximately 700 stocks Morningstar covers and that trade on U.S. exchanges, the broad equity market is trading at a significant discount to fair value. In our view, this is the time for investors to consider adding to their equity exposure. Following the recent rally since the end of September, as of Oct. 21, the broad market is trading at a 19% discount to our fair value estimate.
- Take a look at growth and value opportunities. Breaking our valuations down further, stocks in the growth category are trading at about a 24% discount to their fair value estimates, closely followed by stocks in the value category, which are trading at approximately a 19% discount. The core/blend category is much closer to fair value as it only trades at a 11% discount. According to these calculations, it appears that the best relative positioning is a barbell of an overweight in growth and value and an underweight in core/blend.
A previous version of this article was published on Oct. 27, 2022.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.