The stock market is a poor political handicapper, telling us little about how the two parties will fare in this November's midterm elections. The midterm results are equally unhelpful giving guidance about how the stock market will do subsequently.
The story doesn't end there, though. The six months following those elections are when the seasonal winds in favor of higher prices are particularly strong. Investors should be looking for a significant bottom in the stock market around the time of the midterm elections on Nov. 8.
These conclusions are based on our analysis of the interrelationships between the stock market's performance before and after the midterm elections and how the incumbent party fares in those elections. Surprisingly, no correlations emerged between the stock market's performance and the midterm results that satisfy minimal standards of statistical significance.
Predicting How Many Seats the Incumbent Party Will Lose
You'd think there would be a strong correlation, with poor stock market performance before the midterms correlated with bigger losses for the incumbent party. Indeed, there are many making just such a prediction now, given that the Dow Jones Industrial Average is down 19% so far this year and the Nasdaq Composite is down 31%.
But such a correlation doesn't show up in the data, as you can see from the accompanying chart.
This is surprising, given the factors that political scientists have found to be predictors of midterm results, such as gross-domestic-product growth rates, consumer confidence, and presidential approval ratings. You'd certainly suppose that these factors would also be strongly correlated with the stock market.
This supposition may very well be accurate, but with a time lag, according to Carlos Algara, a professor of political science at Claremont Graduate University. In an interview, he pointed out that the stock market is a discounting mechanism, anticipating what's coming down the pike several quarters hence. So by the time that, say, GDP is actually falling, the stock market may have long since declined and has instead begun discounting the eventual recovery. Without accounting for this discounting that takes place, it can look as though the incumbent party does better in the midterms during bear markets.
The political lesson: Don't look to the stock market for clues as to which party will pick up seats in this coming November's midterm elections.
The Six Months After the Midterms
The results of the midterms appear to have no impact on the strength of the market's rally over the subsequent six months. That's fortunate for stock market bulls, since that six-month period is when the stock market historically has produced well-above average performance.
Its performance during this period is so strong, in fact, that without it the famous Halloween Indicator would disappear. That indicator, which also goes by the term " Sell in May and Go Away ," is based on the apparent tendency for the stock market to produce its best returns between Halloween and May Day and to turn in mediocre returns the other six months of the year. As reported last April in Barron's, however, researchers have found that this pattern traces almost totally to the six-month period following midterm elections.
There appears to be no correlation between the stock market's performance over this seasonally-favored six-month period and the number of seats lost or gained by the incumbent party in the midterms. As you can see from the accompanying chart, the Dow's average six-month gain following the midterms is impressive regardless of whether the incumbent party gains or loses seats. (None of the differences between the four averages plotted in the chart is statistically significant.)
Why would the stock market's post-midterm return be unrelated to the fortunes of the incumbent political party? The authors of the study mentioned above—Kam Fong Chan of the University of Western Australia and Terry Marsh of theUniversity of California, Berkeley—suggest it has to do with the resolution of the uncertainty that exists before the midterms. The stock market suffers because of that uncertainty, and then rallies once that uncertainty is resolved—even if that resolution may not line up with yours or my political preferences.
Mark Hulbert is a regular contributor to Barron's. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited.