Midterm Elections and a Shifting Market

Adam Phillips, Managing Director, Investments

With midterm elections approaching, investors are preparing for a week of political headlines, corporate earnings and economic data. While the election results could influence policy and create short-term market uncertainty, a potentially more significant development is taking shape beneath the surface: broader participation across the stock market.

What History Tells Us About Midterm Elections
Americans head to the polls Tuesday, with control of both chambers of Congress at stake. Recent polling suggests Democrats could gain control of the House and Senate, although several competitive races remain too close to call.

The final outcome may also take time to emerge. In 2022, it took several days to determine which party would control the Senate, with the chamber's final makeup unresolved until a runoff election in Georgia.

Despite the uncertainty surrounding elections, history offers some perspective. Since 1938, the S&P 500 has posted a positive return in the 12 months following every midterm election, averaging a gain of approximately 15%.

While past performance does not guarantee future results, the historical pattern reinforces an important distinction between short-term political uncertainty and the fundamental drivers of longer-term market performance. Corporate earnings, economic growth and interest rates generally have a greater influence on markets over time than the political party controlling Washington.

Market Performance Reveals a Shift Beneath the Surface
Beyond the election headlines, recent market performance points to an encouraging development.

The S&P 500 declined last week following disappointing earnings from several major technology companies associated with artificial intelligence (AI). The index finished October down approximately 1%, reflecting heightened expectations for some of the market's largest companies.

However, the broader market told a different story.

Technology and communication services, which together account for more than 45% of the S&P 500, were the only two sectors to finish October in negative territory. The other nine sectors posted gains.

Meanwhile, the equal-weighted S&P 500, which assigns the same weight to each company rather than emphasizing the largest, gained approximately 5% during the month.

This divergence suggests investors may be rotating away from some of the largest technology and AI-related stocks and toward other areas of the market, rather than abandoning equities altogether.

That broadening of market participation could be a constructive development. For several years, a relatively small group of technology companies has driven a disproportionate share of market gains. Greater participation from other sectors could help reduce the market's dependence on those companies.

The shift does not necessarily signal an end to the AI investment theme. Instead, it may indicate that investors are becoming more selective, placing greater scrutiny on whether substantial AI investments can generate the earnings growth needed to support current valuations.

Earnings, Employment and Policy Remain in Focus
The midterm elections are only one of several significant events on this week's calendar.

Another round of corporate earnings, including Apple's results, will provide additional insight into business performance and investor expectations. Friday's employment report will offer an updated view of labor market conditions and could influence expectations for interest rates.

The election results could also shape future debates over AI investment and regulation, defense spending, tariffs and the federal debt ceiling. Changes in these policy areas may have meaningful implications for individual companies and industries.

However, the relationship between election outcomes and overall stock market performance is rarely straightforward. Attempting to predict the direction of the broader market based on which party wins control of Congress can overlook the economic and corporate fundamentals that ultimately drive investment returns.

Keeping the Bigger Picture in Focus
Political uncertainty may dominate the headlines in the days ahead, but the broadening of market participation offers another important development for investors to monitor.

As some of the largest technology companies face greater scrutiny, gains across other sectors suggest the market's underlying dynamics may be shifting.

Rather than focusing exclusively on election outcomes or short-term market reactions, investors should continue paying attention to economic growth, corporate earnings, interest rates and the longer-term trends shaping financial markets.

Those fundamentals remain central to understanding the market's direction, regardless of the political headlines.

Often quoted in major national media, Adam is a Chartered Financial Analyst (CFA^®), a CERTIFIED FINANCIAL PLANNER™ (CFP^®), and has been included on the Forbes NextGen Best-in-State Wealth Advisors 2019 list. He is a member of the CFA Society of Los Angeles and the CFA Institute. Adam helps establish asset allocation strategy as a member of the EP Wealth Investment Committee, which supports all EP Wealth Advisors and their clients. The Committee’s top-down approach to portfolio construction begins with an outlook on the economy’s likely direction, followed by the implications for different economic sectors and asset classes. This culminates in strategic selection of the individual stocks, bonds, mutual funds or other investments deemed most appropriate for each individual client’s portfolio. 

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Video Transcript: 

Adam Phillips:

Well, it's election week, and if there's one thing investors can probably count on over the next several days, it's no shortage of headlines.

Tomorrow, Americans head to the polls for the midterm elections, and with control of Congress at stake, the results could have some meaningful implications for markets and the economy.

The latest polling suggests Democrats could be headed for a sweep, potentially taking control of both the House and Senate. But as we've learned over the years, polling data isn't always reliable, and a number of individual races remain extremely close.

And we may not have all the answers tomorrow night. Remember, back in 2022, it took several days before we knew which party would control the Senate, and nearly a month before the final makeup was determined following a runoff election in Georgia.

But here's something worth keeping in mind as we head into election week.

Historically, the stock market has performed remarkably well following midterm elections, regardless of which party comes out on top. In fact, going all the way back to 1938, the S&P 500 has been higher in the 12 months following every single midterm election, with an average gain of approximately 15%.

Now, past performance is no guarantee of future results, but I think the bigger takeaway is that while elections can create short-term uncertainty, over longer periods, markets tend to be driven much more by corporate earnings, economic growth, and interest rates than by which party controls Washington.

And that brings me to what's been happening in the market recently. Because while the headlines have focused on disappointing earnings from some of the biggest technology companies, there's actually a more encouraging story developing beneath the surface.

The S&P 500 declined last week as earnings from several major technology companies associated with the artificial intelligence trade failed to live up to some pretty lofty expectations. And for the month of October, the S&P 500 finished down about 1%.

But that headline number doesn't tell the whole story. Technology and communication services, which together now represent more than 45% of the S&P 500, were actually the only two sectors to finish October in negative territory.

Meanwhile, the other nine sectors posted gains. And perhaps even more telling, the equal-weighted S&P 500, which gives each company the same influence on the index, gained approximately 5% for the month.

So what does that tell us? Well, it suggests that what we're seeing isn't necessarily investors abandoning stocks altogether. Instead, it looks much more like a rotation, with money moving away from some of the biggest technology and AI-related names and into other areas of the market. And from a longer-term perspective, that kind of broadening in market participation can be a healthy development.

For the last several years, a relatively small group of technology companies has accounted for an outsized share of the market's gains. So seeing other sectors begin to participate more meaningfully is something we'll be watching closely.

Of course, that doesn't mean the AI story is over. But it does suggest investors are becoming more selective, and increasingly focused on whether the enormous amounts of money being invested in AI will ultimately translate into the earnings growth needed to justify current valuations.

Now, turning back to this week, elections aren't the only thing on the calendar. We also have another important round of corporate earnings, including Apple's results after the closing bell today. And on Friday, we'll get the latest employment report, which should provide another important look at the health of the labor market and potentially influence expectations for interest rates.

So even without the election, this would be a pretty significant week for investors. And looking beyond the immediate results, there are some important policy questions that could emerge from the midterms.

Things like AI investment and regulation, defense spending, tariffs, and the next debate over the federal debt ceiling could all be influenced by the balance of power in Washington.

Those are issues that can have real implications for specific industries and companies, but I'd caution against trying to translate any one election outcome into a simple prediction about where the overall stock market is headed.

Ultimately, the message this week is pretty straightforward. There may be a lot of political noise over the next several days, and we could see some surprises.

But beneath those headlines, we're seeing signs of a market that's becoming broader, with more sectors participating even as some of the biggest technology companies face greater scrutiny.

As always, our focus will remain on the fundamentals: the economy, corporate earnings, interest rates, and the longer-term trends that ultimately drive investment returns.

We'll be watching the election results closely, but we won't let the headlines distract us from the bigger picture. Thanks for watching, and we'll see you next week.