The relationship between elections and financial markets has long fascinated investors and analysts. While political events can certainly impact market sentiment in the short term, the long-term effects of election cycles on stock and bond returns are more nuanced. This article examines the historical performance of financial markets throughout the four-year presidential and congressional election cycle.

In general, the first year after a presidential election often sees markets experience a dip as the new president implements policies and reforms. The second year, known as the midterm election year, is typically the weakest year, characterized by increased volatility due to political uncertainty. The third year, or pre-election year, usually stands out as the strongest for stock market performance. Finally, in the fourth year, or election year, market performance can vary as investors react to campaigns and potential policy changes.

When examining historical data, some aspects of the presidential election cycle theory appear to hold true, while others are less consistent. According to data from the Stock Trader's Almanac going back to 1896, the Dow Jones Industrial Average has shown an average return of 3% during post-election years, 4% during midterm years, 10.2% during pre-election years, and 6% during election years. This data supports the notion that the third year tends to be the strongest for stock market performance.

A study by Morgan Stanley examining S&P 500 returns from 1928 to 2016 found that the average return during presidential election years was 11.3%, with 83% of election years seeing positive S&P 500 performance. Interestingly, a more recent analysis by T. Rowe Price indicated that average S&P 500 returns during non-election years (11.6%) were slightly higher than those during election years (11%).

In a more recent study from Morningstar, strong momentum in a presidential election year has historically carried into the rest of the year and 2024 is no exception with a 19.5% return as of August 31, 2024. That is the 3rd best start to a presidential election year since 1926 and more than doubles the average return in election years of the S&P 500 (8.2%).

Another interesting aspect is how party control affects market performance. Contrary to popular belief, research suggests that full party control of both the White House and Congress does not necessarily lead to stronger stock market performance. U.S. Bank investment strategists found that split party control has often resulted in positive market returns; for instance, a Democratic White House with a Republican Congress typically yields above-average returns, while a Democratic White House with a split Congress also results in above-average returns. Conversely, a Republican White House with a Democratic Congress tends to produce slightly below-average returns.

While much attention is focused on stock market performance during election cycles, bond markets are also affected. Historically, during what is termed the "pause period"—the time between the Federal Reserve's last rate hike and its first rate cut—bonds have outperformed cash significantly. In fact, in the past five Fed cycles since 1990, bonds produced average annualized returns of 14.8% during this pause period compared to just 5% for cash.

Despite potential short-term impacts from the elections, long-term market trends have remained remarkably consistent regardless of political shifts. According to Morningstar, the S&P 500 has produced cumulative returns of an astonishing 1,456,754% since 1926, demonstrating resilience through numerous changes in political control. On average, stocks have risen by approximately 11.6% during presidential election years since 1926—a figure that slightly surpasses the overall average return of about 10.3% in all years.

Historical data reveals an interesting pattern within election years themselves: typically, the first half of an election year shows sluggish performance while stronger returns are often observed in the second half. Notably, the third quarter tends to deliver the highest average return within these years at around 6.2%.

While the presidential election cycle theory provides an intriguing framework for analyzing market performance, it is essential to recognize its limitations. Numerous factors beyond politics influence financial markets, and past performance does not guarantee future results. For investors navigating these complexities, it is crucial to avoid making drastic portfolio changes based solely on election outcomes. Instead, focusing on long-term investment strategies rather than short-term political events will likely yield better results over time. Additionally, understanding that market fundamentals and economic conditions often exert a more significant influence on returns than election cycles can help investors make informed decisions. By maintaining a diversified portfolio and adhering to a well-designed investment plan, investors can effectively navigate potential volatility associated with election cycles while working toward their long-term financial goals.