Midterm elections have arrived and while most of the stock market remains focused on inflation and federal policy, there’s no denying that any surprise on an election day can send the markets in a new direction. Historically, stocks tend to trend downward around an election and then show signs of growth when the election is over. This year’s election cycle may deviate from this trend, however.

Besides an unconventional — and unpredictable — election, the market faces lingering uncertainties, including the Russo-Ukrainian War, North Korea's future direction, bottlenecks in the global supply chain, and a looming international recession.

The outcomes of all these factors lie beyond our control as individual investors, but how we respond to economic factors can affect our portfolios. Let's take a look at 2022's midterms and the market.

US Economic Outlook for Q1 2023

Except for two months during 2020's COVID pandemic, the U.S. economy has remained surprisingly strong. Unemployment numbers are still low, and prices of gas and food have dropped — even if only slightly. Inflation remains a concern, however, and many economists predict a short recession in early 2023 regardless of which party wins control of congress in the fall.

Two factors are driving the upcoming recession: inflation and the Federal Reserve's response to it. Massive public spending and virtually no productivity during COVID have driven down the value of the dollar and caused prices to rise alarmingly fast. To counteract inflation, therefore, the Federal Reserve raised interest rates, inevitably slowing commerce and softening employment projections. As a result of these two factors, a recession may be inevitable.

The word recession is scary, but it simply means a contraction in the business cycle. It doesn't mean we're doomed. In fact, many economists are predicting a rebound by the third quarter of next year with 2023 as a whole showing slight economic growth.

Other macroeconomic factors will also affect the US economy during this time.

While California has historically been one of the most progressive states in terms of its environmental initiatives, a theoretical shift to a more conservative government or a no on Prop 30 (which relates to funding to reduce greenhouse gas emissions) could lead to decreased support for renewable energy and other climate change mitigation strategies. 

How Midterm Elections Traditionally Affect Stocks

Stocks tend to trend downward in midterm years, then show growth in the 12 months after the election. Observers sometimes attribute this pattern to the market's dislike of uncertainty. And nothing is more uncertain than an election. The sitting president's party tends to lose congressional power in a mid-term election, which the market perceives as volatility. 

Research shows though, that the market rarely reacts to a change in leadership over the long term. 

This year's post-midterm performance may deviate from the trend given that polls show some of the tightest gubernatorial and senatorial races in history with many contenders still neck and neck. This could be a bellwether for deeper-seated ideological divisions that could influence market conditions.

S&P 500 Midterm Election Year Seasonal Pattern

Since 1946, the S&P 500 has shown a seasonal pattern. Under Democrat presidents, such as Joe Biden, first-term midterm years average a loss of 0.6%. In these circumstances, May through October is the worst six months followed by a high the following April.

Of course, this is an average over more than half a century of mid-term elections. Each election brought its own unique set of circumstances to the economy. Two years in particular show similarities to 2022. In 1978, inflation was high and a first-term Democratic president was in office. The Democrats performed unexpectedly well, the stock market dove, and then — two months later — largely recovered.

In 1982, Republicans lost congressional seats under a first-term Republican president. Persistently high inflation — similar to current economic realities — may have helped determine this election's outcome. Nevertheless, after the election, the stock market rose significantly and continued to do so almost unabated throughout Reagan's eight years in office.

So far in 2022, the market has shown more erratic performance than usual under President Biden. Some of these ups and downs may reflect the administration's policies. More likely, however, they stem from market fundamentals and other external factors that may lie outside the control of the president.

Why 2022 Could Be Different

The midterms of 2022 are likely to be different from past midterm years due to the looming uncertainty about the future. The election's outcomes still look unclear, gas supply/demand imbalances are increasing, and European inflation is skyrocketing.

The markets will probably also be impacted by other lingering uncertainties like Federal Reserve interest rate hikes and cuts along with the ongoing conflict in Ukraine. It's hard to untangle which of these factors is pulling at the economy the hardest. If it's not the election, then we won't see much change after November.

What we are likely to see is gridlock in Washington. 

Is Gridlock Good for Investors?

Gridlock is defined as a situation in which there is an inability to take action or make progress due to intense disagreement among those involved. Gridlock can be good, bad, or neutral depending on the circumstances. 

Gridlock may be good if it means that politicians cannot take actions that prevent economic growth and therefore nothing changes. Historically, the stock market has thrived when there has been gridlock in Washington. However, gridlock can also mean that nothing at all gets accomplished and therefore public spending projects get cut. It may also be neutral if there are no clear benefits or consequences associated with gridlocked opinions/decisions.

What are the chances of gridlock after 2022?

Almost 100%. 

Currently, Democrats hold the House, the Senate, and the White House. Pollsters predict that Republicans will flip the House and maybe the Senate. With more than one party holding power, very little spending legislation is likely to get passed until after the 2024's elections. 

Which Election Outcomes Could Benefit Investors the Most?

You can expect one of three possible outcomes in the 2022 midterm elections. 

• Republicans win the House or the Senate.

• Republicans with the House and the Senate.

• Democrats hold both the House and the Senate.

If Republicans win one chamber of congress but not both, we will likely see limits to taxation and spending legislation. If they win both chambers, we'll probably see absolute gridlock between Congress and the White House. If the Democrats hold both chambers, however, we can expect them to advance key components of the president's Build Back Better agenda.

While these anticipated outcomes may affect how you vote, they shouldn't change how you invest. Over the long term, market performance is unlikely to change based solely on any one of the above scenarios coming true. National elections alone do not account for all economic growth or shrinkage. Other factors hold much more weight.

What Else Is Affecting the Market?

In 2022, we're seeing an unusual coalescence of unstable geopolitics, rapid inflation, and higher-than-usual food and energy prices. These mostly stem from one of three main factors — the Russo-Ukraine War, ongoing supply chain disruptions, or wholesale price increases. Any or all of these factors could lead to increased volatility in international markets and negative portfolio performance. 

The Federal Reserve's interest rate increases could also have a significant impact on stock prices. There is no way to tell what will happen in a year, but investors can take certain steps now to prepare for possible outcomes.

Will the Stock Market Rally After the 2022 Midterm Elections

Historically, the market performance appears largely independent of which party holds the reins of power in Washington. That's because elections affect investors' emotions, but they do little to change the overall economic climate. This year's post-midterm performance may deviate from the trend due to complex global uncertainties. 

No matter who wins what seat in Congress, most observers predict that early 2023 will bring a short recession. In that same vein, markets are generally already pricing in what is to come. As investors are predicting a recession, they have also positioned their investments as such. Some believe the Dow Jones Industrial Average is likely to fall — likely below 30,000 points. Keep in mind, however, that the Dow only broke through 30,000 points for the first time in November 2020. Thus, economists are not predicting a market crash or anything even close to it.

Best Advice in 2022: Embrace Long-Term Thinking

What should main street investors do in the face of so much uncertainty?

First, think long-term. Unless you plan to pull your money out of the market in 2023, position your investments in long-term strategies. . You're investing for your future, not your present.

Second, stay diversified. Just because the market overall shows a decline doesn't mean every sector takes a dive. Various areas of the markets react differently to a recession. 

Third, stay in touch with your wealth management professional. If you aren't working with a professional, you should be. A certified financial planner™ professional can help you consider the facts and make sound financial choices that will pay off later.

In conclusion, stock prices are likely to be impacted by other lingering uncertainties in the market. Despite what stocks have done in the past, we don't know what will happen this time around. There are many lingering uncertainties from 2020 that are still unresolved. 

We do know this: a diversified portfolio with an eye on the future is often every investor's best bet. 

All investing involves risk and past performance does not guarantee future performance. Diversification does not ensure a profit or protect against a loss.