The Sophomore Slump: How Midterms Affect the Stock Market

Ella York - Teen Aspect - May 17th, 2022
 

As the 2022 midterms approach, it might be a promising idea to keep an eye on the stock market. Chances are that this year is going to be a doozy. But with so many unprecedented circumstances, it’s easy to ignore the larger pattern that has made itself abundantly clear over the last century. Despite these highly unusual times, there is a cycle that can be traced back to the early twentieth century. The fact of the matter is that midterm years are consistently more volatile and lower in average annual returns than other years. The only question is, why?


To start off, it’s worth mentioning that this year could be even more of an outlier than those in the past. With the COVID-19 pandemic, Russia’s invasion of Ukraine, and inflation higher than we’ve seen in 30 years, it’s clear that the uncertainty factor is at an all-time high. This means that regardless of midterms, the market has already proven highly variable, which lowers consumer confidence ratings.


Now, what do consumer confidence ratings have to do with midterms?


In short, quite a bit.


Multiple studies have been conducted and research has been gathered that shows the almost identical rates of consumer confidence and presidential approval. The Gallup Poll, conducted by the University of Michigan, is one of the most widely recognized and trusted of these studies. It shows a relationship that is almost perfectly proportional between consumer confidence and presidential approval. The only major discrepancies can be found during the Trump administration, where the approval rating does fall below consumer confidence; however, it does remain in a proportional relationship.

In one article recently published by Paul Whiteley and Harold Clarke (2021), they state, “The results show that presidential approval and consumer confidence move together in a dynamic equilibrium over time; they rise and fall together.” This is incredibly important, as it shows how much influence the state of the economy can have on voters. If the market becomes more volatile, then consumers will no longer be looking to invest in the same way that they would during a steadier market. The more variable stocks are, the harder it is to invest in an informed manner. This inevitably leads to lower consumer confidence, which in turn affects presidential approval rates. This is mainly because the state of the economy is often what sways voters still on the fence. If the economy is good, then swing voters are more likely to vote for the party in power.

There are a few other interesting sequences that could be influential when trying to predict the market after this year’s elections.

Annual returns during midterm years have, historically, been significantly lower than in other years. There are many reasons that people speculate could cause this trend, however there are a few points in particular that likely have the biggest effect. One important statistic to consider is how the market varies in years that we have presidential elections. The idea that the simple presence of a potential change in party control is responsible for these numbers just doesn’t hold up. Year after year, presidential elections have shown the same levels of variability and nearly equal annual returns when compared to years entirely without elections. This is quite an interesting occurrence, as it might make sense that the market varies more when there is any change in the political balance of power. So, if this isn’t what causes such extreme irregularity, what about midterms makes them so subject to fluctuation?

The answer could lie in the nature of politics itself.

The president is, primarily, a politician. It doesn’t matter what party they belong to or what their policies are; the president wants to get reelected. During the last year of their term, most presidents start to really invest in the economy, as that is a surefire way to boost approval ratings, as stated above. This means that government spending will reach an all-time high (compared to the rest of their term) during the last year. Markets prefer big government spending, which is what makes investing in the economy during the last year so attractive. Donald Trump’s presidency is a great example of this. The S&P 500 returns of his second year were his lowest, dropping 6.2%, before rising dramatically in his third year by 28.9% (Cook, 2021).

However, when presidents save stimulating the economy for their final term, often as a last-ditch effort to sway swing voters, it often means that the second year of their term goes through a slump of sorts. Once the excitement and drama of the presidential election has passed, the president must go through the more mundane process of actually governing. While there is always something happening regarding politics, the more exciting and intriguing aspects of the job are temporarily put on hold. Since the president isn’t actively campaigning during their second year, the economy tends to fall. This ‘sophomore slump’ is what causes the lower annual returns that we see every year during midterms.

Now, all of this information is great and dandy, but the important bit is how this could affect this year’s midterms. There are a few separate ways to look at it.

For starters, the historical path seems to be that whichever party currently has the presidency generally loses seats in Congress (The American Presidency Project, 2018). It seems that everyone’s a critic when they aren’t the ones in charge, and people are led to believe that any issues they have with the current administration could be fixed by voting the opposition into congressional power. This is a pattern we’ve seen emerging year after year, with a few notable exceptions being Franklin Roosevelt’s first term, William Clinton’s second term, and George W. Bush’s first term (US House of Representatives, 2021). But disregarding that, this a trend that holds true.

Now we obviously have a Democratic president in Joe Biden. Regardless of how you feel about him personally, his current approval ratings are extremely low, and have continued to tank as inflation continues to increase and gas prices remain higher than ever. This doesn’t exactly bode well for Democrats this coming November. With states like Florida gaining members, it seems likely that Republicans will take back the majority in Congress.

However, all is not lost for the left just yet.

In a study conducted by the CFRA research group in a partnership with Forbes (Klebnikov 2022), it shows that the S&P 500’s average annual return rates varied based on the political alignment of both the president and Congress. According to the article, the highest return rates always occurred with a Democratic president in power. Interestingly, a split Congress paired with a Democratic president seemed most favorable to the market, and the second highest was with a Democratic president and a Republican Congress.

It seems that while the market does prefer more government spending, it also enjoys the restraint that a divided or Republican Congress can exhibit. I can only assume that this makes everything a bit more predictable, as it puts a check on how much power the president has.

In relation to this year’s midterms, it does seem as though the Democrats might give Congress up to the Republicans. But this could prove beneficial to the Democrats as we approach the 2024 presidential election.

The lull in the economy that we’ve seen is entirely normal (of course, that’s disregarding all the major historical events that we’ve borne witness to in the past two years). The pattern generally goes so that in the months directly following midterms, the market gets a rather large boost (Tepper, 2022). So even though the market is going through a low right now, chances are that by the time of the 2024 election it’ll have shot back up, regardless of who’s in charge in Congress. Even though the Democrats might lose a little ground during midterms, this could actually help them win the presidency.

If Republicans control Congress (or just even things out), the economy will most likely get an even greater boost than it would have otherwise (Sommer, 2022). When you compound this with the natural rise and fall of the market, it seems like 2023 and 2024 could be good years for investors. And as we’ve seen, when the economy is good, approval ratings are good. This could mean that swing states might lean a little more left in this upcoming presidential race.

Personally, this is how I tend to think it’s all going to play out. Unless something truly drastic happens (again), it seems like the economy might begin to bounce back after the hit it took when COVID initially began. No matter what side of the political aisle you fall on, it’s hard to deny the reality of the current patterns, and it would be foolish to ignore them. It seems like during this year’s midterms, everyone’s going to have to lose some to win some. And if that isn’t a perfect representation of the give-and-take system of modern politics, then I truly do not know what is.



References

The American Presidency Project. (2018, October 29). Seats in Congress gained/lost by the President's Party in mid-term elections. Seats in Congress Gained/Lost by the President's Party in Mid-Term Elections | The American Presidency Project. Retrieved April 27, 2022, from https://www.presidency.ucsb.edu/statistics/data/seats-congress-gainedlost-the-presidents-party-mid-term-elections

Klebnikov, S. (2022, January 24). Here's what happens to the stock market if Republicans take Congress in November. Forbes. Retrieved April 27, 2022, from https://www.forbes.com/sites/sergeiklebnikov/2022/01/19/we-looked-at-how-the-stock-market-performs-during-midterm-election-yearsheres-how-2022-may-be-worse/?sh=68aed7a22562

Party government since 1857. US House of Representatives: History, Art & Archives. (2021). Retrieved April 27, 2022, from https://history.house.gov/Institution/Presidents-Coinciding/Party-Government/#:~:text=Since%201857%2C%20the%20government%20has,and%2025%20under%20Republican%20control.

Sommer, J. (2022, April 22). Why midterm election years are tough for the stock market. The New York Times. Retrieved April 27, 2022, from https://www.nytimes.com/2022/04/22/business/stocks-elections-midterm-biden.html

Tepper, T. (2022, March 8). 3 ways the midterm elections could impact the stock market. Forbes. Retrieved April 27, 2022, from https://www.forbes.com/advisor/investing/midterm-elections-stock-market/

Whiteley, P., & Clarke, H. (2021, December 13). Persistent inflation seriously threatens the Democrats' chances of controlling Congress in the 2022 midterm elections. USAPP. Retrieved April 27, 2022, from https://blogs.lse.ac.uk/usappblog/2021/12/10/persistent-inflation-seriously-threatens-the-democrats-chances-of-controlling-congress-in-the-2022-midterm-elections/

The American Presidency Project. (2018, October 29). Seats in Congress gained/lost by the President's Party in mid-term elections. Seats in Congress Gained/Lost by the President's Party in Mid-Term Elections | The American Presidency Project. Retrieved April 27, 2022, from https://www.presidency.ucsb.edu/statistics/data/seats-congress-gainedlost-the-presidents-party-mid-term-elections

Cook, J. (2021, October 28). Presidential election cycle theory. Investopedia. Retrieved April 27, 2022, from https://www.investopedia.com/terms/p/presidentialelectioncycle.asp

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