Much Ado About Mid-Terms

November 7, 2018

The mid-term elections are now behind us, seemingly having been built up to be a large market event, then just fading away as the day of the elections came and went.  Certainly, the markets were down ahead of the election.  Was the election the cause?  Maybe.

Elections by their very nature are a catalyst for uncertainty.  The market reacts to uncertainty with volatility, and the market essentially is making its best judgment each and every moment where results will land after an election actually occurs.  The further out from an election, the wider the range of possibilities, but the more time we have until it happens.  The closer we get, the more predictability (as a result of polling or research).  The famous forecaster Nate Silver put the chances of the Democrats taking control of the House at 7 in 8.  What happened?  The odds turned out to be dead on.

Historically, we can see uncertainty in the markets leading up to elections.  Let’s look at the past 5 elections in the U.S in the chart below.  The first column looks at the biggest decline in the S&P 500 sometime within the two months leading up to the election.  The second column looks at the performance of the S&P 500 the month after the elections.

What can this chart tell us?  One thing for sure is that negative returns leading up to an election at some point in time are typical.  This gets back to uncertainty.  Any time uncertainty presents itself in the market, there is a potential for negative returns.

The other takeaway you might get is that markets go down ahead of an election, so get out ahead of them.  Then you can see markets go up after, so get back in then.  While that may seem apparent from this chart, there are many reasons why this isn’t the case.  Here are a couple of notable ones:

  • Time periods – All of the negative returns shown above just mean at some period the market was negative in the two-month period leading up to the election.  Sometimes it was nearly for the whole two months, other times it was for a couple weeks or even just a couple of days.  To get this right, you would need to know the exact days of these pullbacks.
  • Remembering 2008 – Ten years removed, this is still a market lesson that keeps on being taught.  The same data above for 2008 would have shown the market down from its high point to low point by -33.9% leading up to the election.  That’s consistent (though a far greater magnitude) with the data above.  However, post-election, if you would have followed the trading strategy of getting right back in when the election ended you would have seen your investment plummet an additional -15.5% over the following month.  That drawdown alone is bigger than the sum of all the positive movements the month after an election shown above.  So much for that trading strategy.

This leaves us sitting here after an election in a relatively familiar spot.  Elections are now over, so that uncertainty is out.  Now the news cycle shifts to the next uncertain thing, and there are plenty – trade, taxes, continued Brexit talks, inflation worries, geopolitical risks, tech, and many more.  While it’s interesting to try to guess what the market will do as a result of any of these, guessing is never a good investment strategy.  Instead, preparing the portfolio ahead of the inevitable and continuous uncertainty is the way to go.

The S&P 500 Index is widely regarded as the best single gauge of the U.S. equities market, this world-renowned index includes a representative sample of 500 leading companies in leading industries of the U.S. economy. Time periods shown above for the decline use the ticker IVV (iShares S&P 500 Index) and are as follows: 2008: 9/2/2008-10/27/2008.  2010: 9/20/2010-9/23/2010. 2012: 9/14//2012-10/26/2014.  2014: 9/17/2014-10/16/2014.  2016: 9/6/2016-11/4/2016.  2018: 9/20/2018-10/28/2018.

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