My aunt makes the best Italian meatballs. I remember watching her when I was a child. She did not use a written recipe or measuring cups and yet, the end product was perfect. She would add a dash of garlic and a pinch of cheese to her masterpiece. I realize now that a great deal of trial and error went into her work, allowing her to eventually perfect her recipe.

It seems American voters also have been experimenting in order to find the perfect political recipe. In fact, in the last six elections, including both presidential and midterm, voters have removed the party in power five out of the past six times. In other words, voters seem to express their lack of satisfaction with the amount of progress in Washington, D.C. by trying all possible combinations between the president and both houses of Congress, attempting to get better results. As we approach the congressional elections this November, markets are once again trying to figure out what voters have in store this time around.

First, a disclaimer: I will just be discussing the history of midterm elections in Washington and market implications. This will not be an editorial on which policy or political configuration is better or worse, philosophically.

Approval Rating Matters

This midterm election is shaping up like history says it should — with the ruling party losing the majority in one or both chambers of Congress. There is a very strong historical relationship between the president's approval rating and the number of seats the president's party loses in Congress. Given that President Trump's approval ratings continue to hover around 40%, Democrats remain the early favorite to regain control of the House. In mid-April, PredictIt, an online futures market of political events, gave Democrats about a 70% chance of gaining the 24 seats needed to achieve a simple majority in the House, but as of this writing this number has fallen to the low 60s. The Democrats also need two seats to gain control of the Senate; PredictIt has given a 29% chance of this happening.

Seasonality Is a Factor

Markets have traditionally struggled in the months leading up to the midterm election itself. In my opinion, uncertainty seems to be the greatest culprit here as markets always tend to bide their time when an outcome is unknown until the date it is resolved. The uncertainty often delays fresh capital coming into the markets, as most investors seem content to wait until after the outcome is known before deploying capital. Since 1962, monthly market returns in midterm years have averaged -1.1% from April to September. (See Exhibit 1.)

But the performance of equity markets change prior to and following midterm elections as uncertainty fades. In particular, the fourth quarter of midterm election years is quite strong. And the good news doesn't stop there. Since 1962, one-year equity returns have always been positive and have averaged a gain of 31% from the market low of the midterm election year. (See Exhibit 2.) In addition, since the midterm election of 1950, the S&P 500 has never been negative one year following Election Day, and returned an average of 15.3%.

Will This Election Be Different?

While the above numbers are comforting, we must constantly be diligent in assessing shifts in Washington and how the markets react to them. In fact, this midterm election cycle may already be exhibiting a different pattern than its predecessors. One of the theories as to why the midterm election cycle pattern is persistent is that the typical president chooses policies that cause fiscal pain early in their presidential tenure, only to provide stimulus in years three and four. This is done to improve his or her chances for re-election, as the economy will be strong and/or improving on Election Day. President Trump has turned this pattern on its ear by introducing fiscal stimulus early in his presidential tenure. The return patterns seen in May 2018 could be an early indication of this change. Historically, the month is negative during midterm election years, averaging -1.7% since 1962. This year's May return was up 2%. While too early to tell if this is the start of a new return pattern in midterm election years, it certainly has our attention.

Our Investment Strategy Committee, which I chair, recently examined this cycle, its possible outcomes and the potential impact on the markets. The most likely scenario, and one that the market is anticipating, is that the majority in the House moves to the Democrats while the Senate remains in Republican hands. Under this scenario, the equity markets should see little movement. As this is the most likely outcome, current market prices probably already reflect this. If the Republicans were to maintain control of the House and the Senate, the Committee believes that this may be the most bullish outcome for markets as it is unexpected. With a continued Republican majority in control, Congress could make their tax cuts permanent or take other stimulative measures for our economy, such as infrastructure. If the Democrats were to once again take both the House and the Senate, talk of impeachment and unwinding of fiscal stimulus may cause equity markets to react negatively.

Sell in May and Go Away?

As summer approaches, pundits will talk about the well-known trading adage that warns investors to sell their stock holdings in May to avoid a seasonal decline in equity markets. Because of the potential for increased volatility ahead of the elections, investors may wonder whether this is a prudent strategy. It is not. Yes, markets may be more volatile throughout the summer months, but leaning into the weakness, not out, may actually prove to be the best strategy. Instead, investors should take a longer-term view, which we believe remains sound with strong underlying economic growth, reasonable valuations within most asset classes and benign inflation. So while it is prudent to consider both the history of election years and the current cycle, fundamentals remain the key ingredients when making asset allocation decisions, not the election event itself.

Voters will have their day at the polls in November as they look for that perfect recipe they believe will put this country on the right path. Perhaps, one day, this country will find it. Until then, we will monitor election outcomes and their impact on markets while continuing to base asset allocation decisions on fundamentals that will drive long-term investment results.

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