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Will Volatility Turn Out For the Election?

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October 1, 2014
Will Volatility Turn Out For the Election?

The stock market has already been rewriting history this year. American voters may be poised to do the same as mid-term elections loom. Predictions and polls aside, Election Day often produces surprises, meaning investors may want to prepare to play politics with their portfolios.

Ask many pollsters, and they’ll probably tell you the Republicans are a near lock to keep the speaker’s gavel in the House of Representatives following Election Day on November 4. The Senate contest? It remains close, but this year is widely considered to be the GOP’s best statistical chance in years to snatch the majority control that the Democrats have held since 2007. In total, all 435 seats in the House and 36 Senate seats (21 held by Democrats, 15 by Republicans), will be decided.

That’s enough uncertainty to keep Wall Street on edge. There’s also a complex brew of economic and geopolitical factors, including lackluster U.S. job growth, the Federal Reserve’s expected transition toward higher interest rates, Europe’s struggles, and conflict in Iraq, Ukraine, and elsewhere.

“Many issues could affect the economy and financial markets from a government action—meaning increased regulation—and a geopolitical point of view,” says JJ Kinahan, Chief Strategist at TD Ameritrade. “So we see great potential for increased stock market volatility heading into mid-term elections, as many outcomes are not as ‘sure’ as we have seen in past contests.”

Elections raise many questions for investors. Might any regulatory shifts pressure industries such as energy and financial services? Will that, in turn, boost the prospects for technology and renewable energy solutions? Will dominance of one party goose the economy enough to benefit cyclical stocks, including consumer discretionary, or is a political stalemate the best “hands off” formula for continued private-sector job creation and economic growth?


Rock The Vote

In the short term, the broader U.S. stock market has historically logged a respectable average 2.7% gain in the eight trading days that bookend mid-term election day, said Jeffrey Hirsch, editor in chief of Stock Trader’s Almanac. Hirsch credits the move to general optimism from an empowered Wall Street that believes it has exacted “change” in Washington.

A wider historical lens, however, suggests stock market underperformance often precedes mid-term elections. According to Sam Stovall, chief equity strategist at S&P Capital IQ, the average S&P 500 index performance for the second quarter prior to a mid-term election was a decline of 2.5%. By comparison, the average second-quarter performance for all years since World War II was a gain of 2.7%. The third quarter remains weak by comparison in mid-term election years as well.

So-called defensive stock sectors, including consumer staples and health care, historically performed the strongest in mid-term election years, with average total returns of 3.1% and 1.5%, respectively, since 1970. Financials and utilities have been the worst-performing, with average losses since 1970 of 4.5% and 4.4%. It’s not only large-caps in the mid-term slump; the Russell 2000 small-cap index also logged its weakest quarters in mid-term years, with an average decline of 3.5% in the second quarter and 6.6% in the third quarter since 1978.

Now, what about after the confetti is swept up and the grind of Washington begins? History has shown that markets generally snap back (see figure 1). It’s true that the two worst quarters of the four-year “presidential cycle” tend to hit during mid-term election years, which of course are in the middle of a president’s term. But they’re typically followed by the three strongest quarters, according to Stovall.

In the six months following mid-term elections since 1970, the S&P 500 averaged a gain of 15.8%, compared with an average gain of 3.9% in November–April all other years (for this year through September, the index was up 6.7%, compared to an 18% gain during the first three quarters of 2013).

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FIGURE 1: POLITICAL HEADWINDS. The second and third quarters of mid-term election years (red bars, circled) historically underperform the rest of a four-year presidential cycle. Source: S&P Capital IQ.  For illustrative purposes only. Past performance does not guarantee future results.

History Rewritten?

Here’s the rub: This year’s stock market, at least until October, turned the tables on history. The S&P 500 gained 5% in the second quarter (and closed above 2,000 for the first time in late August), which leaves some investors ready to scrap the election history books as they position for what’s next. Some are wondering, if stock gains came early in the election-year cycle, could that mean a post-election correction?

As the mid-terms neared, the U.S. market tumbled from record highs while once-slumbering volatility readings soared. In mid-October, the CBOE Volatility Index, or VIX (aka the “fear” gauge), spiked above 28 to reach the highest levels since late 2011 (see figure 2).

Outside Noise

Christopher Ciovacco, founder of Ciovacco Capital, argues that the stock market’s gains so far this year, along with other factors such as Middle East and Ukraine turmoil, position 2014 to potentially buck a historical trend.

“It may be fair to say that the mid-term election year pattern calling for a correction in stocks has very little to do with mid-term elections, given the bearish events that occurred in 1982, 1990, 1998, and 2010,” Ciovacco wrote on his blog. “It is also fair to say that the odds of a market correction will be higher in any year that contains an event similar to the Falklands War, Gulf War, Russian Debt Default … or the European debt crisis.”

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FIGURE 2: VOTER ANXIETY? The CBOE Volatility Index (VIX), after holding near historic lows much of the spring and summer, surged near a three-year high in mid- October (red), suggesting growing uncertainty. Source: CBOE, TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future performance.

Now, no one is predicting outright war or financial catastrophe. The point is, news events can upend political campaigns and record stock market runs at unexpected moments. Similar to 1982, 1990, 1998 and 2010, the markets in 2014 “will be driven primarily by the economic and geopolitical events of the day, rather than a historical election year or chart pattern,” Ciovacco added.

Plenty of questions linger over the outlook for 2015 and the sustainability of a U.S. bull market now heading toward its sixth birthday, especially as Wall Street settles in with a new-look Washington. Study up on your candidates— it’s also a good time to review portfolios for potential political risk.

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