TIMOTHY A. CLARY

The US midterm elections will be held on November 3, about three and a half weeks from now. The S&P 500 closed above 7,800 for the first time on October 6, ending the session at 7,818.93 and taking its year-to-date gain to about 14%. Over the same period, the market has been expecting third-quarter earnings for S&P 500 companies to rise about 29.5% year on year, according to FactSet. If realised, it would mark the third consecutive quarter of growth above 25%.

The market’s current level has prompted Wall Street to revisit a familiar set of historical figures. Research by Deutsche Bank strategist Jim Reid found that, in the 20 midterm election cycles since the Second World War, the S&P 500 has never posted a negative return in the nine months following the election. Bank of America’s statistics show that the index rose in every cycle over both the six- and 12-month periods after the vote, while it gained in nine out of 10 cycles over the three-month period.

But these patterns mainly concern the period after the election. The historical record before the vote is far less favourable. Since 1950, the S&P 500 has gained an average of about 4.6% in midterm election years, making it the weakest year of the US president’s four-year term. Citing Bloomberg data, Bank of America said this year’s gain was well above the midterm-year average of about 3%, making it the strongest midterm election year since 2006.

The pre-election question: the market has already risen sharply

Goldman Sachs said that, since 1974, the median return for the S&P 500 from early August to polling day in midterm election years had been about zero, compared with a median gain of about 6% in the three months after the election. In other words, if this year’s rally has come early, there may be less room for a further post-election advance than the historical average would suggest.

Strong earnings, but valuations are also expensive

Earnings have been the market’s strongest support this year. FactSet data showed that analysts raised, rather than cut, their earnings forecasts during the third quarter, contrary to the usual pattern. Third-quarter revenue is expected to rise about 12% year on year. Growth, however, has been uneven: earnings expectations for the semiconductors and related equipment industry have jumped 126%, while those for the communication services sector have risen about 51%. For Meta Platforms, expected earnings per share increased from US$1.05 to US$6.74.

On valuations, Robert Shiller’s data compiled by Multpl showed the S&P 500’s cyclically adjusted price-to-earnings ratio, or CAPE, at 41.43 in mid-June. Several data sources have put the measure at around 41 in recent months. Its historical high was 44.19 in December 1999, while its long-term average is about 17.4 and its median about 16.1. In other words, valuations are higher today only than during the dot-com bubble. The peak in 2021 was about 38.6, below the current level.

Starting from such a high valuation, even if the historical pattern continues to hold, a further substantial rise will depend more on earnings being delivered than on a further surge in market enthusiasm.

Two variables could disrupt the pattern

The first is interest rates. Markets are watching whether the Federal Reserve will raise rates. CME FedWatch showed that the probability of a rate increase in October had fallen to about 20% by early October. The Federal Open Market Committee will meet on October 27 and 28. If inflation data comes in above expectations, rate-hike expectations could build again, putting high-valuation stocks under the greatest pressure.

The second is geopolitics and oil prices. The US-Iran conflict has pushed up oil prices. West Texas Intermediate crude was trading at about US$91 a barrel in early October, affecting inflation expectations as well as pressure on the governing party’s election prospects. For multinational companies, trade policy and the US dollar will also affect earnings. About one-quarter to 30% of the revenue of S&P 500 companies comes from markets outside the US.