Can U.S. stocks weather midterm election volatility?

RBC Capital Markets analyzed stock market behavior during the second half of the last two midterm election cycles in 2018 and 2022. Unlike presidential election years, when stocks typically gained, these periods were marked by market volatility. The S&P 500 reached its high in early fall, fell in October, then rose again in November before dropping once more in December.

Despite the turbulence, RBC's chief strategist Lori Calvasina explained that the volatility helped establish more resilient lows that endured into the following year. Factors such as Federal Reserve and interest rate concerns, trade policy in 2018, and the tech earnings recession and Russia-Ukraine war in 2022 contributed to the market swings.

Consumer Staples and Health Care sectors outperformed during the downturns, while Technology and Consumer Discretionary lagged. After the market recovered, Financials, Industrials, and Materials led the gains, while Communication Services, Consumer Staples, and Health Care trailed behind. Calvasina emphasized that while the team does not predict a repeat of this volatility, examining potential tail risks is valuable, particularly concerning the timing of market inflections.

Currently, high price momentum is outperforming in recent trading for the S&P 500 and Russell 2000, while EPS quality is lagging. Second-quarter earnings calls highlighted a complex environment, with companies facing geopolitical risk, inflation, supply chain issues, and low housing turnover, alongside strengths in AI, energy, and reshoring-related industries.

The market generally rises when deal activity remains high, only experiencing problems once that activity ceases. Forward price-to-earnings ratios for the S&P 500 and Nasdaq 100 are in the middle of their post-COVID range, while the Russell 2000’s forward P/E is closer to average levels. Despite these valuations, RBC remains optimistic on the S&P 500 for the coming year, citing the interest rate environment as the primary risk.

The strategist anticipates pullbacks to remain within a 5-10% range unless there is a surge in recession or interest rate shocks, giving Growth and U.S. equities a slight advantage over Value and non-U.S. markets.